Receiving shares of a private company (e.g., through a stock option exercise or RSU settlement) is an exciting milestone. However, that excitement can quickly turn to sticker shock when you realize you owe taxes – often in cash – on stock you cannot yet sell.
Historically, employees of startups and private companies faced a brutal dilemma: exercise your options or settle your RSUs, then come up with the cash to pay income tax (often at ordinary rates) on illiquid stock. You couldn’t sell the stock to cover the taxes because there was no public market.
The Section 83(i) election, added by the Tax Cuts and Jobs Act of 2017 (TCJA), was designed to solve that problem by allowing qualified employees of private, eligible corporations to defer income tax on certain “qualified equity grants” for up to five years. 🗓️
This post provides a comprehensive, 1,500+ word guide to Section 83(i), including the legal requirements, how to make the election, state tax conformity, serious risks, and practical pitfalls.
📜 Background: The General Rule Under Section 83(a)
Under the general rule of Section 83(a), when a person receives property (like stock) in connection with performing services, the fair market value (FMV) of the property is included in gross income in the first year that the property is either (1) transferable or (2) not subject to a substantial risk of forfeiture (i.e., vested) – whichever occurs earlier.
For an employee of a private company, this is problematic: they are taxed on the FMV of the stock on the vesting/exercise date, but they cannot sell the stock to pay the tax liability.
⚖️ The Section 83(i) Election: The Five-Year Deferral
Section 83(i) provides an exception. If a qualified employee makes an 83(i) election with respect to qualified stock, then the income that normally would be included under Section 83(a) is deferred until the earliest of five triggering events described below.
⚠️ Important: The 83(i) election is only available for qualified stock received in connection with the exercise of a non-qualified stock option (NSO) or the settlement of a restricted stock unit (RSU). Incentive stock options (ISOs) are not eligible.
✅ Requirements for a Valid Section 83(i) Election
An 83(i) election is not available to everyone or for every stock grant. Several specific requirements must be met.
📌 1. The Stock Must Be “Qualified Stock”
“Qualified stock” means stock in the employer corporation that is received:
- (a) In connection with the exercise of an option or settlement of an RSU; and
- (b) The option or RSU was provided in connection with the performance of services as an employee; and
- (c) The option or RSU was granted by an eligible corporation.
An eligible corporation is generally a private company that has a written plan under which at least 80% of all U.S. employees are granted stock options or RSUs with the same rights and privileges in the calendar year the award is granted.
💡 IRS Notice 2018-97 clarified that the 80% requirement applies separately to options and RSUs – you cannot mix and match to reach 80%. The IRS also stated that employers may opt out of Section 83(i) entirely by, for example, not establishing the required escrow arrangement.
📌 2. The Employee Must Be a “Qualified Employee”
A “qualified employee” is any employee who:
- (a) Is not an excluded employee (defined below) at any time during the calendar year of grant, the exercise/settlement date, or the 83(i) election.
- (b) Agrees to meet the escrow and withholding requirements described in the statute.
- (c) Has not previously made a Section 83(b) election with respect to the same stock.
🚫 What is an “Excluded Employee”?
An excluded employee is an individual who, at any time during the calendar year or in any of the prior 10 calendar years, is or was one of the following:
- The CEO or CFO of the corporation (or an individual acting in such a capacity).
- One of the four highest compensated officers of the corporation for the taxable year (determined under SEC rules).
- A 1% owner of the corporation (directly or indirectly).
- An employee who is (or has been in the prior 10 years) a family member of a 1% owner or a highly compensated officer.
👩💻 Practical Tip: Founders, C-suite executives, and major shareholders are generally excluded – the 83(i) election is designed for rank-and-file employees.
📌 3. The Employer Must Establish an Escrow Arrangement
To ensure that income tax withholding obligations can be satisfied when the deferral period ends, the deferral stock must be deposited into an escrow account before the end of the calendar year in which the 83(i) election is made. The stock must remain in escrow until the employer recovers the income tax withholding obligation.
If an employer fails to establish an escrow arrangement, the employee cannot make a valid 83(i) election. Employers can effectively block the election by not providing the required escrow.
🗓️ The Five-Year Clock: When Does Deferral End?
If a valid 83(i) election is made, the income that would have been included under Section 83(a) is deferred until the earliest of the following events:
| Triggering Event | Description |
| (i) | The qualified stock becomes transferable (including transferability back to the employer) |
| (ii) | The employee becomes an excluded employee (e.g., promoted to CFO or becomes a 1% owner) |
| (iii) | Any stock of the corporation becomes publicly traded on an established securities market |
| (iv) | 5 years after the employee’s rights in the stock first became vested or transferable |
| (v) | The employee revokes the 83(i) election (in a manner prescribed by the IRS) |
⚠️ Critical Risk: When the deferral ends, the amount included in income is determined as of the original vesting/exercise date – not the eventual FMV when you finally sell. If the stock value declines, you may owe tax on an amount far greater than what you actually receive.
For a real-world analogy, similar issues arose in tax court cases where taxpayers were taxed on illiquid stock that later proved to be worthless – look by analogy to cases like Estate of Kunze v. Commissioner (discussing Section 83(a) valuations).
📝 How to Make a Section 83(i) Election
1️⃣ Timing: The 30-Day Window
The election must be made no later than 30 days after the first date on which the employee’s rights in the stock are transferable OR are not subject to a substantial risk of forfeiture (i.e., vested), whichever occurs earlier.
⏰ If you miss the 30-day deadline, the election is lost forever for that grant. No extensions.
2️⃣ Election Procedure (Similar to a Section 83(b) Election)
The procedure is described in Treas. Reg. § 1.83-2 by analogy (since no separate regulations for 83(i) have been finalized). The election must be made by filing a written statement with the IRS containing:
- Your name, address, and taxpayer identification number (SSN).
- A description of the property (e.g., number of shares, type of stock).
- The date the property was transferred (vesting/exercise date).
- The taxable year for which the election is made.
- The nature of any restrictions on the property.
- A statement that you have provided a copy of the election to your employer.
You must file the election with the IRS by certified mail (return receipt requested) to the IRS Service Center where you file your tax return.
You must also provide a copy of the election to your employer.
3️⃣ Employer Notice and Reporting Requirements
Employers must provide written notice to eligible employees at the time (or a reasonable period before) the employee’s rights in the stock become substantially vested. Failure to provide the notice can result in a **50,000 per calendar year.
Employers must also report:
- W-2 Box 12, Code GG: The amount included in income in the calendar year from qualified equity grants under Section 83(i).
- W-2 Box 12, Code HH: The total amount of income deferred under Section 83(i) as of the close of the calendar year.
4️⃣ Withholding: Maximum Rate Required
When the deferral ends, the employer must withhold income tax at the maximum rate in effect for individuals under Section 1 (currently 37%) – regardless of the employee’s actual tax bracket or withholding allowances.
💰 Your employer will withhold at 37% federal income tax. You will get a refund if you are in a lower bracket when you file your return – but you must front the cash at the maximum rate.
🗺️ State Tax Conformity: A Patchwork of Rules
While Section 83(i) provides deferral for federal income tax purposes, state income tax treatment varies dramatically.
📍 Rolling Conformity States
Approximately half of the states that impose an income tax use rolling conformity – they automatically conform to the current Internal Revenue Code (including Section 83(i)). In these states, the deferral should generally be honored for state purposes.
📍 Static Conformity States
Static conformity states conform to the IRC as of a specific date (e.g., January 1, 2015). If that date is before the enactment of Section 83(i), the state may not recognize the deferral.
📍 Selected Conformity States
A minority of states have selective conformity – they adopt some federal provisions but not others. Section 83(i) may or may not be adopted.
🧾 Practical Guidance
| State | General Approach |
| California | Conforms to the IRC as of January 1, 2015 (static). Since Section 83(i) was enacted in 2017, California currently does not conform for personal income tax purposes. |
| New York | Generally conforms to the IRC, but specific conformity dates vary. Consult a NY tax advisor. |
| Texas, Florida, Nevada, Washington, Wyoming, South Dakota, Tennessee, Alaska, New Hampshire | No state income tax – no issue. |
⚠️ Warning: Even if your state conforms for personal income tax, it may not apply the same maximum withholding rules regarding escrow and reporting. You should consult with a qualified state tax professional.
⚠️ Major Risks and Pitfalls of Section 83(i)
1️⃣ Tax on Depreciated Stock
The single biggest risk: your deferred tax liability is based on the FMV at the time of vesting/exercise, not when you eventually sell. If the stock value declines or the company fails, you could be forced to pay tax on an amount you never actually receive.
2️⃣ Maximum 37% Withholding
Even if you’re in a lower tax bracket, your employer is required to withhold at the maximum rate of 37% when the deferral period ends. You may be due a refund on your tax return, but you must front the cash.
3️⃣ Early Trigger Events
The deferral ends at the earliest of several events. A promotion that makes you a 1% owner or a CFO could cause immediate inclusion. An IPO by the company (even if you can’t sell all of your shares) also triggers inclusion.
4️⃣ FICA and FUTA Taxes Are Not Deferred
Section 83(i) only defers income tax (federal and potentially state). FICA (Social Security and Medicare) and FUTA (unemployment) taxes are due in the year of vesting/exercise, even if you make the 83(i) election.
5️⃣ Employer Deduction Is Deferred
If an employee makes an 83(i) election, the employer’s compensation deduction is deferred until the employer’s tax year in which (or with which) ends the tax year the employee includes the amount in income. This may be a negative for the employer.
🧭 Practical Steps: A Checklist for Employees
If you are considering making a Section 83(i) election, use this checklist:
- ✅ Confirm the stock is qualified stock from an eligible corporation.
- ✅ Verify you are a qualified employee (not an excluded employee under the 1% owner or highly compensated test).
- ✅ Ensure your employer has established the required escrow arrangement.
- ✅ Confirm that no Section 83(b) election has been made with respect to the same stock.
- ✅ Prepare the 83(i) election statement (modeled after Treas. Reg. § 1.83-2).
- ✅ File the election with the IRS (certified mail, return receipt requested) within 30 days of vesting/exercise.
- ✅ Provide a copy to your employer.
- ✅ After filing, ensure your employer uses maximum rate withholding (37%) upon the deferral ending.
- ✅ Plan for FICA/FUTA taxes due in the current year.
- ✅ Consult with a state tax professional to determine if your state conforms to Section 83(i).
🏁 Conclusion
The Section 83(i) election can be a powerful tool for rank-and-file employees of private companies to defer federal income tax for up to five years on qualified equity grants. However, the election is riddled with technical requirements, traps (like the 30-day filing deadline), and significant risks (such as being taxed on depreciated stock).
Before making an 83(i) election, you must carefully review your eligibility, ensure your employer has satisfied its notice and escrow obligations, and – most importantly – consult with a qualified tax professional familiar with both federal and state tax laws.
📢 Disclosure
Disclaimer: Tax laws, regulations, and judicial interpretations (including Sections 83(i), 83(b), and related provisions of the Internal Revenue Code) are subject to frequent change. New legislation, IRS rulings, administrative guidance, and court decisions may modify, eliminate, or reinterpret the rules discussed above. The information provided here is for general educational purposes only and does not constitute legal or tax advice tailored to your specific circumstances. Reliance on this information without independent professional guidance may result in adverse tax consequences, including interest and penalties.
For personalized advice, questions about your specific situation, or assistance with preparing or filing an 83(i) election, please contact: 📧 Alan Goldstein
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