IRS Issues New Rules on Stock Options

Recently issued proposed regulations will change the way employers treat the exercise and disposition of stock acquired through an incentive stock option (ISO) plan.

NQSOs

Employer deduction. Sec. 83(h) allows employers to deduct as compensation amounts included in employees' income. If the options are not readily tradeable, the income would occur when the employee exercises the options. Under Regs. Sec. 1.83-6(a), income from nonqualified stock options (NQSOs) is deemed included in an employee's income as long as the employer timely issues either a Form W-2 or 1099. If the employer fails to do this, the deduction would be allowed only if the employee actually included the income on his return.

Employer withholding. Compensation income from the exercise of NQSOs is considered wages for employment tax purposes. Employers must withhold income taxes (at the flat rate on supplemental wage payments), and the income is subject to FICA and FUTA taxes. If an employer fails to withhold income taxes, tax payments made by the employee could be used to offset this withholding obligation, but the employer may be subject to failure-to-withhold penalties.

Because income occurs at the time of exercise of NQSOs, employers usually are in a position to meet the required withholding obligations. For example, in Letter Ruling 9025078, an employer was allowed to reduce the number of shares delivered to the employee on the exercise by the amount of withholding needed. The employer then remitted these funds to the IRS.

Another alternative is to include a provision in the stock option agreement under which the employer will not issue stock to the employee pursuant to the exercise of the NQSOs until the employee has provided the necessary cash to the employer to make the withholding payments.

ISOs

Employer deduction. Because em-ployees do not have income at the time of the exercise of an ISO, there is no compensation deduction at that time. If, however, there is a disqualifying disposition of the stock acquired, the disposition would create compensation income for the service provider for the difference between the strike price and the stock's fair market value (FMV) at the time of exercise. A disqualifying disposition is a disposition of the stock within either two years from the date of the option grant or one year from the date of option exercise.

If a service provider enters into a disqualifying disposition, the employer can deduct the amount in the year it is included in the service provider's income. As with NQSOs, the deemed-inclusion rule allows employers to take a deduction as long as the income is properly reported to the employee as required. However, under Regs. Sec. 1.83-6(a), a W-2 or W-2c would be deemed to be timely filed for this purpose if it were issued on or before the date on which the employer files its tax return claiming the deduction.

Withholding. Historically, the IRS has accorded special treatment to ordinary income resulting from the disqualifying disposition of an ISO. According to Rev. Rul. 71-52, this type of income did not constitute wages for FICA, FUTA and Federal income tax withholding. Notice 87-49 amplified this and noted that this income was exempt from withholding. However, when the taxpayer in Sun Microsystems Inc., TC Memo 1995-69, challenged the determination as to whether income resulting from a disqualifying disposition of an ISO was wages for research-and- development-credit purposes, the Tax Court found that this income should be considered wages. The Service acquiesced in Sun Microsystems.

In January 2001, the IRS issued interim guidance in the form of Notice 2001-14. The notice indicated the Service intended to assess FICA, FUTA and income tax withholding requirements on statutory stock options, beginning on Jan. 1, 2003. Because the IRS does not intend to assess FICA or FUTA tax on the exercise of statutory options until Jan. 1, 2003, the notice also allows employers who have withheld FICA or FUTA tax prior to the notice to seek refunds.

Proposed regulations. In November 2001, the IRS issued proposed regulations intending to clarify the current law in this area. These proposed regulations state that an employee has wages for FICA and FUTA tax purposes at the time of the ISO exercise. An employer must withhold and remit FICA and FUTA taxes based on the difference between the strike price and the stock's FMV when the options are exercised. The proposed regulations also state that as long as the employee does not recognize income at the time of the exercise of the options under Sec. 421(a)(1), no income-tax-withholding requirement exists on exercise.

Concurrent with the issuance of the proposed regulations, the Service issued Notices 2001-72 and 2001-73, intended to provide rules of administrative convenience for employers complying with the new regulations. Notice 2001-72 provides that an employer is not required to withhold income taxes on the disqualifying disposition of stock acquired through an ISO. It also provides that to claim a deduction for the wages attributable to a disqualifying disposition of an ISO, the W-2 the employer issues to that employee must include this income.

Notice 2001-73 provides certain methods and approaches an employer can use to account and pay for the FICA and FUTA tax liability arising from the ISO exercise.

The proposed regulations are effective when finalized and apply to options exercised after Jan. 1, 2003. The rules of administrative convenience outlined in Notices 2001-72 and 2001-73 are not effective until the IRS issues final rules, which are expected to accompany the issuance of the final regulations.

From Robert F. Kane, J.D., CPA, Baltimore, MD