New Tax Law’s Equity Grant Rule Not Too Useful for Startups

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By Lydia O'Neal

Employees of startups who get paid in restricted stock units are now allowed to delay paying taxes on it, but tax professionals think doing so might pose more risk than benefit.

While employees of these fledgling businesses can avoid paying income taxes on their restricted stock units for five years under new code Section 83(i) in the 2017 tax law, they are still essentially betting on a startup’s success, practitioners said.

Additionally, employment law and tax attorneys told Bloomberg Tax, widespread use of the deferral may be limited by the code section’s narrow real-world application, the need for IRS guidance, and the likelihood that many new and small businesses don’t know about it.

“We don’t think that these smaller companies, unless they’re advised by larger accounting firms or law firms, will know about this ability to defer tax under 83(i),” said Sanyam Parikh, an attorney at the Raleigh-based law firm Wyrick, Robbins Yates & Ponton LLP, who specializes in employee benefits and equity compensation.

“To the extent that they are advised and do know about it, it’s still not clear that employees will take advantage of the deferral election, just because of the risk.”

How It Works

Under Section 83(a) of the code, which existed before Section 83(i) was added in the tax law ( Pub. L. No. 115-97), the value of property transferred in exchange for performed services is included in income when it vests, meaning the employee has become fully entitled to and able to sell it.

Section 83(b), which also existed prior to the new law, allows employees with private company restricted stock units to elect within 30 days of the transfer to have the fair market value of the stock taxed as income, so that, as the value of the stock ideally rises over time, they can maximize the amount of share value later taxed at the capital gains rate rather than the much higher income tax rate. Otherwise, employees would pay income tax on the restricted stock units when they vest—potentially a much higher value than when it was transferred.

For low- to mid-level employees at a young startup, paying income tax on a stock they can’t sell, even when the shares hold much lower value when they’re transferred than when they vest, is far from ideal.

The new Section 83(i), which practitioners said was likely intended to benefit nascent tech, biotech, and pharmaceutical firms, defers the income tax obligation on qualified equity transfers for five years. It must be provided to at least 80 percent of employees and exclude: chief executive officers; chief financial officers and their spouses, children, grandchildren, and parents; one percent owners of the company; and the four highest-compensated company officers.

To help employees make the most of Section 83(i), a company within half a decade of a liquidity event would give the equity grants to low- and mid-level personnel so they can wait until after the stock can be sold on a securities marketplace to pay the income tax on the value at which it was initially transferred to them, and capital gains tax on any increase in value since then. Practitioners said what sounds great in theory may in reality still tie employees to the risk that the company will bottom out. The provision may be little used—or worse, used inadvertently at the risk of penalty, they said.

For a ‘Sophisticated Employee’

For starters, 80 percent of a business’s employees can be a big number, and the grant would be most attractive to a “sophisticated employee,” rather than one who is unfamiliar with equity and far removed from the company’s initial public offering or sale strategies, said J. Marc Fosse, director of the California-based employee benefits law firm Trucker Huss APC.

“They’re going to provide it to a broad base of people to do this, but I don’t know that that broad base, that a significant amount, will take this into consideration unless they feel confident that a liquidity event is on the horizon,” he told Bloomberg Tax.

Responsibility for disclosing the obligations associated with the Section 83(i) grant rests on the employers, so it may lead to more communication regarding the company’s strategy, Fosse continued.

“But if I was an employee and there wasn’t a liquidity strategy that I knew about,” he said, “it would be difficult for me to really take advantage of the 83(i).”

Failures and Fluctuations

Although qualified equity grants could help non-executive staff get more in touch with the company’s future risks and valuation, and the new five-year deferral could make them more attractive, Section 83(i) still doesn’t save employees from startups’ inherent risks of failure and fluctuations in value, said Norman Stein, a professor at the Drexel University Thomas R. Kline School of Law.

“If you have a rational evaluation of the startup based on how many startups fail, maybe it’s not such a great election to make. But people are incredibly optimistic. I think the vast majority of people who can make this election do make it because they expect the stock to go way up,” he said. “If you make the election and the stock goes down in value or the stock collapses and becomes worthless, you still owe the tax.”

Many small companies may simply not know about 83(i), as it’s an under-the-radar change to the tax code compared with, say, the 14 percentage point drop in the corporate rate, Parikh said. Accounting firms and tax lawyers, he added, are in most cases prohibitively expensive for a business in the early stages of funding.

Definition, Please

The absence of guidance on certain aspects of Section 83(i) may further obstruct its widespread use, practitioners told Bloomberg Tax. The code section, for example, bars companies with stock traded on an “established securities market” from administering the grants, but doesn’t explicitly define eligible and ineligible markets.

In addition, the 80 percent figure applies to “all employees who provide services to such corporation in the United States (or any possession of the United States).” This may pose problems, especially for the tech industry, which has employee networks that span multiple continents. Additionally, while the employees granted the restricted stock units don’t need to each hold the same number of shares, they must all have “the same rights and privileges,” a characterization on which practitioners said they would need guidance.

Confusion aside, businesses unaware of the new section may easily grant their employees restricted stock units that fit Section 83(i) by mistake, Parikh and his colleague at Wyrick Robbins, Thomas Cook, agreed. If a company has a small number of employees, other than the CEO, CFO, one-percent stakeholders, and four highest-compensated officers, it could easily meet the 80 percent threshold necessary for a qualified equity grant under Section 83(i) by giving restricted stock units to, say, four or all five of those employees. If the startup fails to disclose to them that they can make a Section 83(i) election to defer their income tax payments, Parikh and Cook said, the employers could be penalized.

“A lot of smaller companies doing things on the cheap—looking at LegalZoom or some cheap version of doing this rather than paying a lawyer who’s more likely to understand these rules—they may or may not fall or back into a qualification,” Cook said. “If you’ve got two or three founders and one secretary, it’s probably going to be a qualified equity grant if that’s the only option you give out that year.”

To contact the reporter on this story: Lydia O'Neal in Washington at loneal@bloombergtax.com

To contact the editor responsible for this story: Meg Shreve at mshreve@bloombergtax.com

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