What is an 83(i) Election and How Do You You File One?

Employee equity compensation, such as Restricted Stock Units (RSUs) or Non-Qualified Stock Options (NQSOs), is a relatively common way for companies to attract and retain talent. However, as appealing as these forms of compensation may be, they can result in sizable and unexpected tax bills. 

In an effort to help employees manage their tax liabilities more effectively, the Internal Revenue Code offers provisions like the “83(b) election”, which allows employees to pay tax on the fair market value of restricted stock at the time of its granting as opposed to vesting. Along with the 83(b) election, there is a less well-known provision—the 83(i) election—that offers other tax advantages to certain types of employees. 

In this article, we’ll examine the 83(i) election, its benefits and drawbacks, and whether it’s the right choice for you. 

Table of Contents

1. What is an 83(i) election?
2. The key differences between 83(i) and 83(b) elections
3. The benefits and risks of an 83(i) election
4. The eligibility criteria for an 83(i) election
5. How to file an 83(i) election
6. 83(i) compliance requirements for companies
7. Is an 83(i) election right for you?

What is an 83(i) election?  

An 83(i) election is an IRC provision that allows certain employees of private companies who receive RSUs or NSOs to defer federal income tax on the exercise or settlement of their stock for up to 5 years. 

Before 2017, employees who received RSU or NSO equity compensation faced a dilemma. If the value of their stock had appreciated substantially since the grant date, this could create a liquidity issue for them, with employees needing to sell their shares to pay the tax due on the shares—and potentially at an unfavorable time.

In many cases, however, employees didn’t have the option to sell their shares because the company was still private. As a result, they were left holding valuable stock certificates that came with a sizable tax bill they couldn’t pay.

The issue was particularly problematic for non-executive employees who didn’t have the financial resources to cover these kinds of unexpected tax obligations. Consequently, it wasn’t unheard of for employees to decline equity compensation altogether because the tax risk was too great.

The 83(i) election was introduced as part of the Tax Cuts and Jobs Act of 2017 to address this issue. Its goal was to make equity compensation more accessible to a broader range of employees and not just high-ranking executives. With the provision allowing eligible employees to defer taxes for up to five years, an 83(i) election provides the breathing room needed for employees to manage their tax liability more effectively.

The key differences between 83(i) and 83(b) elections

While both the 83(b) and 83(i) elections are tools for managing tax liabilities on equity compensation, they serve different purposes and have distinct rules. 

83(b) election:

Purpose: An 83(b) election allows an employee to immediately pay income tax on the value of restricted stock or stock options received, even though these assets may not yet be fully vested or exercisable. 

Benefit: Electing to pay taxes upfront allows the employee to effectively treat the restricted stock or options as if they were fully vested, and taxed at the ordinary income tax rate. This may be advantageous if the employee anticipates a significant increase in the value of the stock, as subsequent long-term gains will generally be taxed at the more favorable capital gains rate.

83(i) election:

Purpose: An 83(i) election allows employees to defer the recognition and payment of income tax on certain stock options or restricted stock units (RSUs) for up to five years following the vesting or exercise date. 

Benefit: 83(i) provides employees with the additional time needed to generate the necessary liquidity to cover their tax obligations. This can be particularly beneficial in situations where an employee may not have the immediate financial resources to satisfy the tax burden associated with the award.

It’s important to note, however, that 83(i) eligibility is restricted to non-executive employees, and at least 80% of U.S.-based employees must receive similar equity grants.

Choosing between the two:

The following table summarizes the key differences between an 83(b) election and an 83(i) election.

The decision between an 83(i) and an 83(b) election also depends on the type of equity you receive.

• Restricted Stock: In the case of restricted stock, you receive shares directly, but they are subject to vesting conditions. An 83b election can be made upon receiving these shares, allowing you to pay taxes on their current value upfront and potentially reducing future tax burdens.
• Stock Options: Should you receive stock options, you’ll gain the right to purchase shares at a specific price (strike price) in the future. An 83(i) election can be made upon exercising these options, deferring the tax liability on the option’s value for up to five years.

As a general rule, if you anticipate significant stock appreciation, an 83(b) election is perhaps the better option as it allows you to pay taxes upfront and a potentially lower amount. However, if immediate liquidity is a concern, an 83(i) election provides greater flexibility.

Choosing whether to file an 83(b) or 83(1) election involves various factors, including your financial situation, the company’s growth potential, and your long-term goals. Consulting with a tax advisor from Harness can help you understand the complexities and implications of an 83(i) election in-depth, and can help you make the right decision for your specific needs.

 

The benefits and risks of an 83(i) election 

Tax deferral is the primary advantage of an 83(i) election, allowing employees to delay paying taxes for up to five years. This deferral can be vital to employees who lack the immediate funds needed to cover substantial tax bills upon vesting or exercise.

A further benefit of an 83(i) election is liquidity management. With the provision allowing the deferral of taxes, employees avoid the need to sell shares immediately just to meet tax obligations. This helps preserve ownership and grants employees the opportunity to benefit from potential long-term gains, should the company’s value appreciate. Additionally, if the stock’s value increases after the deferral period ends, further appreciation is generally taxed at the capital gains tax rate. This rate is typically lower than the ordinary income tax rate, especially for long-term capital gains.

Ultimately, an 83(i) election grants employees more control over their financial strategies, allowing them to maximize the value of their equity compensation while reducing the immediate impact of potential taxes. This can be particularly advantageous for employees who anticipate company growth and want to retain their shares.

Risks and limitations  

One of the primary risks of an 83(i) election is the potential for stock value decline. If the stock’s value decreases during the deferral period, employees still owe taxes based on the stock’s higher fair market value at vesting or exercise. With fair market value (FMV) defined as the price at which a willing buyer and a willing seller would agree to transact an asset in an open and unrestricted market, this creates a situation where the tax liability may exceed the value of the stock when sold.

In short, this can mean employees have to pay taxes on gains they never actually received.

Another limitation of an 83(i) election is the possibility of deferral triggers. The deferral period may end unexpectedly, such as if the company goes public or if the employee leaves the company before the stock is fully vested. In these cases, the taxes owed would be triggered earlier than expected, which could disrupt the employee’s financial planning.

Additionally, there are complex eligibility rules associated with the 83i election (which we will outline in the next section). Both employees and companies must meet strict criteria to qualify, with failure to do so leading to potential disqualification of the election.

These limitations may leave some employees ineligible for the deferral benefits. Given the substantial impact that an 83(i) election can have on an employee’s tax liability, gaining the advice of a seasoned tax expert to make sure you qualify for the correct provisions is an important step in the process.

It’s also important to note that an 83(i) election is only possible if the employer establishes the necessary conditions, such as setting up an escrow arrangement for deferral stock. Employers have the discretion to opt out of permitting 83(i) elections by declining to establish these conditions or explicitly excluding the election from equity compensation plans. Employees should confirm their employer’s stance before assuming eligibility.

The eligibility criteria for an 83(i) election  

The IRS outlines clear criteria for the types of employees, stock, and corporations that are eligible for an 83(i) election. 

Employer Authorization

To file an 83(i) election, employers must authorize the necessary conditions for the election to be valid. For example, employers need to establish an escrow arrangement for deferral stock to ensure compliance with income tax withholding requirements. Without these conditions, employees are unable to make an 83(i) election, even if they meet all other eligibility criteria.

Eligible employees

An eligible employee is one who works for a company that agrees to pay taxes on stock options or RSUs according to the IRS’s rules. Certain employees, however, are excluded.

Excluded employees:

• 1% Owners: Employees who own 1% or more of the company, either at any point during the calendar year or within the last 10 years.
• C-suite executives: The CEO, CFO, or any individual who has served in those roles at any time.
• Family members: Close family members of the CEO or CFO, as defined in Sec. 318(a)(1).
• Highest-compensated officers: The top four highest-compensated officers of a corporation, based on compensation disclosures under the Securities Exchange Act of 1934, are also excluded.

Eligible stock

For stock to be considered eligible, it must be granted through stock options or RSUs tied to employee services during a calendar year in which the company qualifies as an eligible corporation. Non-qualified stock includes options that offer cash instead of stock or allow stock to be sold back to the company when vested.

Eligible corporations

To be eligible for an 83(i) election, a corporation must meet the following criteria:

Non-publicly traded stock: The company must not have stock traded on a securities market during the prior year up to the election.

Broad-based equity plan: At least 80% of U.S.-based full-time employees must receive stock options or RSUs with similar rights and privileges. It’s important to note that while the rights and privileges must be similar, the number of shares granted to each employee can be different, as long as a significant number of shares are available to all eligible employees.

This 80% requirement applies only to full-time employees working 30 hours or more per week during the calendar year. The IRS clarifies that this requirement cannot be accumulated over multiple years, and the corporation must track eligibility based on stock options or RSUs granted within the current year. If a corporation is part of a controlled group, it is treated as a single entity for purposes of this election.

How to file an 83(i) election 

The correct filing of an 83(i) election requires employees to follow specific steps and timing requirements to ensure eligibility and compliance.

Employees must also be aware that an 83(i) election depends on employer cooperation. Employers can preclude elections by not setting up the conditions required under IRS rules, such as establishing an escrow arrangement for deferral stock. It’s important to consult with both your employer and a tax advisor to confirm eligibility before attempting to file an 83(i) election.

An 83(i) election must be filed within 30 days of the earliest of the following events:

1. The date when the employee’s rights in the qualified stock become transferable, or  
2. The date when the stock is no longer subject to a substantial risk of forfeiture.

To file the election, employees should prepare documentation similar to a 83(b) election. This includes a written statement that must be submitted to the IRS and a copy provided to the employer. The statement should clearly indicate the intent to make an 83(i) election and contain all necessary details about the stock and vesting date.

Certain limitations apply. An employee can’t file a 83(i) election if:

• They have already made an 83(b) election for the same stock.  
• If stock of the issuing corporation is publicly traded on an established securities market at any time before the election is made.

In addition to this, an 83(i) election is not applicable to nonvested stock where an employee has chosen to report income under 83(b). 

83(i) compliance requirements for companies 

To comply with the 83(i) election rules, companies have to meet several obligations related to notice, reporting, deductions, and tax withholding.

Employers have the ability to opt out of permitting employees to make an 83(i) election. This can be done by explicitly stating in the terms of the stock option or RSU grant that no 83(i) election is available or by declining to establish necessary conditions such as an escrow arrangement. This ensures employers maintain control over the application of 83(i) elections within their equity compensation plans.

Notice requirement  

Employers must notify employees of their eligibility for the 83(i) election. This notice must be provided either when the employee’s right to the qualified stock becomes substantially vested or within a reasonable period beforehand. Failure to provide timely notice can result in a fine of $100 per violation (with a maximum penalty of $50,000 per year).  

Reporting requirement  

Employers are responsible for accurate reporting on employee W-2 forms:  

• Box 12, Code GG: Report the income included in the calendar year from qualified equity grants under IRC Section 83(i).
• Box 12, Code HH: Report the total amount of deferred income under Section 83(i) as of the end of the calendar year.  

Additionally, employers must give the electing employee a written statement detailing: 

1. The amount to be included in gross income for the tax year when a statutory inclusion event occurs.
2. The total deferred income under the 83(i) election as of the calendar year-end.  

Deferred employer deduction  

If an employee makes an 83(i) election, the employer’s tax deduction for the qualified stock is deferred. The deduction is available in the employer’s tax year that corresponds with the employee’s tax year in which the deferred income is recognized.  

Withholding requirement  

When the deferred income is finally included in the employee’s income, employers must withhold federal income tax at the maximum individual rate of 37%. This ensures proper tax collection at the time of inclusion.  

Is an 83(i) election right for you? 

The decision to file an 83(i) election is a strategic one. The 5-year tax deferral offers distinct advantages to employees who may lack the liquidity needed to meet immediate tax obligations, however, an 83(i) election may not be the right choice for everyone due to eligibility restrictions and potential risks.

Personal financial situations, future stock performance, and liquidity constraints all play a key role in determining its effectiveness.

It’s also important to consider state tax implications as well as federal income tax. In California, for example, RSU income is considered compensation income, which means in addition to income tax, it’s subject to payroll taxes such as federal Social Security tax, Medicare tax, and California State Disability Insurance.  

The need for professional tax advice

The varied and significant factors that impact the effectiveness of provisions like an 83(i) election require the insight and experience of qualified tax professionals.

Tax advisors, like those you can meet at Harness, can provide the tailored guidance needed to help both employees and employers gain the maximum benefits of equity compensation schemes while minimizing their tax liabilities. 

Whether it’s determining optimal provisions, understanding the impact of different tax jurisdictions, or the complexities of RSUs, tax advisors at Harness can provide the necessary insights. With our team analyzing the specific circumstances of each client and situation, we can help optimize tax strategies, identify potential pitfalls, and ensure compliance.

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Tax related products and services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness Wealth”. Harness Wealth Advisers LLC is a paid promoter, internet registered investment adviser. Registration does not imply a certain level of skill or training. This article should not be considered tax or legal advice and is provided for informational purposes only. Please consult a tax and/or legal professional for advice specific to your individual circumstances.

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