Recommend Our Site to Your Friends!

Print This Page

By Michael Gray

IRS Issues Proposed Payroll Tax Guidelines For ISOs and ESPP.

The IRS has issued proposed regulations under Internal Revenue Code Sections 424, 3121, 3306 and 3401 relating to the application of FICA, FUTA, and income tax withholding relating to incentive stock options (ISOs) and employee stock purchase plans (ESPP). (REG-142686-01.)

You might recall that the IRS previously issued Notice 2001-14, which suspended penalties for not withholding payroll taxes relating to ISOs and ESPPs exercised before January 1, 2003.

The proposed regulations, if finalized, would be effective for ISOs and ESPPs exercised after December 31, 2002.

Under the proposed regulations, the excess of the fair market value ON THE DATE OF EXERCISE over the option price would be subject to FICA (social security), Medicare, and FUTA (unemployment) taxes.

Notice the tax applies on the date of exercise, not on the date of sale. Further, THERE IS NO ESCAPE HATCH for employment taxes. For income tax reporting, if the stock acquired from exercising an ISO is sold during the year of exercise for an amount less than the fair market value on the date of exercise, ordinary income is measured based on the excess sales price over the option price, provided the disposition is a sale or exchange with respect to which a loss (if sustained) would be recognized. (IRC Section 422(c)(2).)

Also, FOR INCOME TAX REPORTING, THERE MAY BE NO COMPENSATION INCOME, provided the holding requirements are met. (Internal Revenue Code Sections 422(a) and 423(a).)

The IRS justifies this position by stating that, although there is an exception in the Internal Revenue Code for income tax reporting purposes, that exception does not apply for employment taxes. Therefore, statutory stock options, including ISOs and ESPPs, should be treated the same as non-qualified options for employment taxes.

The IRS decided not to impose income tax withholding relating to ISOs and ESPPs. However, the employer is required to report any compensation income relating to the sale of the ISO or ESPP shares on the employee's (or former employee's) Form W-2. If the employer claims a deduction for the compensation income, the IRS may impose penalties for failing to report the income on the employee's Form W-2. The IRS made this position clear in Notice 2001-72.

Rules of administrative convenience are provided in Notice 2001-73. The employer may report the income subject to employment taxes on several different periods. Examples would be by pay period, monthly, quarterly, or annually (on December 31). Employers other than those who elect to report all of the income on December 31 may elect to treat the income from options exercised during December as paid during the first quarter of the next calendar year. Reporting can be accelerated for employees who terminate employment. The employee may arrange to have FICA and Medicare taxes withheld in advance of exercising the options. Employers may advance the funds to employees to pay the taxes and be reimbursed by the employees later.

Observations. First, remember these are proposed regulations and may be changed after the IRS receives comments. There are proposals in Congress, right now, to exempt ISOs and ESPPs from employment taxes.

Second, most employees who exercise these options will eventually be over the income limitations for FICA ($80,400 for 2001) and FUTA ($7,000 for 2001). If the employer elects to report the income on December 31, there may be minimal additional tax to withhold for Medicare (1.45% for 2001). Some employees, especially those who terminate employment early in the year, will be forced to sell some of their option shares to pay the taxes.

These proposals definitely put another nail in the coffin for ISOs, which are already on the ropes because so many taxpayers were hurt by the alternative minimum tax during the stock market boom and bust.

The issues the IRS has raised show serious drafting errors when these tax provisions were enacted in the first place. Clearly, Congress originally did not intend for the stock received from exercising ISOs and ESPPs to be subject to any taxes until the stock was sold. Also, Congress must have intended the measurement of income and timing for payroll tax reporting to coincide with the income tax treatment, so the part of the income qualifying for reporting as capital gains should not be subject to employment taxes.

Hopefully Congress will be able to give the matters the attention they deserve before the IRS issues final regulations.

IRS Circular 230 Disclosure:

As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.

Consult with a tax advisor

For our readers who aren’t tax advisors, this newsletter is intended to alert you about tax issues that could affect you. It is not a substitute for advice from a professional tax advisor. You will find that getting advice from a qualified advisor is a worthwhile investment. We intend to eventually publish a directory of ESOAA members who are committed to helping clients with employee stock option issues.

Tax advisors should view the newsletter as an alert to become aware of issues relating to employee stock options for further research and study.

(Michael Gray is the co-author of Employee Stock Options – A Strategic Planning Guide for the 21st Century Optionaire. You can order the book at http://www.amazon.com or http://www.barnesandnoble.com/ or buy it at Stacey’s Books.)

P.S.

To receive the next issue of Michael Gray, CPA's Option Alert with more employee stock option tax developments and answers to questions from our readers automatically via email, subscribe by filling out the form below.