One of the constant gripes employees have about stock grants and stock options, particularly in small and start-up companies, is the tax cost to receiving what are supposed to be incentives to help contribute to the company’s success and increase the value for everyone. They are usually forced with a choice to either sell some or all of the stock to pay the tax or come up with the cash from other sources, a heavy toll and a disincentive to participation. Introducing: the Qualified Equity Grant – a new kind of plan designed to alleviate this problem and at the same time create a level playing field to keep the benefits broadly available.
The Tax Cuts and Jobs Act (TCJA) passed in December 2017 provides tax benefits to employees of certain start-up companies under a new Internal Revenue Code (IRC) section §83(i). Under this plan an employee can generally make a special election with respect to qualified stock transferred to them, so that no amount is included in income when the stock is vested or transferable. Absent the election the difference between the fair market value and strike price at the time of vesting is ordinary income included in W-2 wages. Where an inclusion deferral election is made with respect to an incentive stock option (ISO) (including one under an employee stock purchase plan), the TCJA provides that the option is treated as a nonqualified stock option (NQSO) for FICA purposes. Meaning that while there is no income tax due there will still be FICA tax due at the time options are vested.
The effect of the election is to delay the inclusion of this income for five years. The amount included in income at the end of five years is the same amount it would have been absent the election and is still ordinary income. The increase in value over that time is capital gain. In order to obtain this benefit the employee must make an election within 30 days and if elected the income taxation can be deferred by the employee until the earliest of (1) five years, or (2) the occurrence of a specified event such as the stock of the company being readily tradable on an established securities market, or (3) a revocation of the election. The idea being that after five years a small or start up company will mature enough such that at least some liquidity will be available for the stock.
These Grants truly are for everyone. In order to provide these benefits to employees the plan must be written and provide that at least 80% of the employees of the company are granted stock options or RSUs with the same rights and privileges. The 80% eligibility requirement is met only if affected employees (new hires or existing employees) are either granted stock options or restricted stock units for that year and not a combination of both. C-level, the four highest compensated employees, 1% shareholders, and related persons are ineligible to participate in this plan. Certain notice requirements that require employers to provide information to recipients in order to enable them to make informed decisions and/or be subject to penalties apply.
There are some downsides in administration and who can participate. However, this plan may be a great new option for companies that want to offer option plans and help employees afford to participate, so it should be among the plans for consideration. As always, please consult your tax advisor for more information.