Review of Stock Option Treatment in Final Tax Reform Bill
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On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act into law. The bill that was finally passed was the result of several rounds of revisions and hotly contested debate in both the House and the Senate. As we had previously written about, here and here, part of the debate surrounding the final bill was the treatment of stock options.
Both the House and the Senate’s initial versions of the bill included proposals to fundamentally change the treatment of nonqualified deferred compensation, including stock options. Specifically, the initial versions of the bill included a provision requiring the recognition of “ordinary income” upon vesting of such nonqualified deferred compensation instead of upon exercise or some other liquidity event. Had this change been implemented, it would have drastically affected the ability for private companies to use any type of nonqualified deferred compensation in lieu of cash compensation. The reason for this is clear, if stock options were taxed upon vesting, individuals who received such options would be taxed on the difference between the fair market value of the option and the exercise price of the option at the time of vesting (even though they would not have the ability to sell such shares on the public market because the company issuing the shares was private). Being taxed on such “paper gains” is highly burdensome and can be unmanageable if the person being taxed does not have other sources of income to cover such additional tax obligation.
Thankfully for those in the startup community, the final bill did not include any of the above proposed fundamental changes to the treatment of nonqualified deferred compensation.
The final bill did, however, include a new Section 83(i) which allows for certain employees of certain private companies to defer recognition of stock options or restricted stock units (“RSUs”). Under the new 83(i), eligible employees of a private company that grants stock options or RSUs to at least 80% of full-time employees, may elect to defer recognition of any such income until the earlier of (i) the date that is 5 years from the date of vesting of such stock option or RSUs or (ii) the date on which the stock becomes freely transferrable to another party (whether through company buy-back or initial public offering). Eligible employees must file an election for this deferred treatment within 30 days from the vesting of such stock options or RSUs. Additionally, for the 80% threshold, companies may not combine the amount of RSUs and stock options that they have issued, they must count RSUs and stock options separately. Further, even if the company is an eligible company, there are certain excluded employees who are not eligible for this deferred treatment, including individuals who have been CEO or CFO and individuals who have owned more than 1% of the company in the current year or any of the previous 10 calendar years.
While this deferred treatment could allow employees to exercise their stock options or RSUs closer to their vesting date, and thus allow them to start the clock for capital gains purposes, Section 83(i)’s market impact may be muted because of the complexity of its requirements and the narrow scope of the companies that it applies to.
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