IRS Proposes Employment Tax on the Exercise of Statutory Stock Options

In Nov. 14, 2001, the Service issued proposed regulations that would impose employment taxes on the exercise of statutory stock options (i.e., incentive stock options (ISOs) under Sec. 422 and options granted pursuant to an employee stock purchase plan (ESPP) under Sec. 423). The proposed regulations will apply to the exercise of statutory stock options as of Jan. 1, 2003.

Background

In Rev. Rul. 71-52, the IRS ruled that qualified-stock-option exercises were not wages for payroll purposes or subject to employment taxes. Also, when an employee sold the stock, employers did not have to withhold Federal income taxes. When ISOs replaced qualified stock options in the early 1980s, employers continued to exclude statutory-stock-option exercises from income tax withholding and FICA and FUTA taxes.

In Notice 87-49, the Service indicated that it was reconsidering the holdings of Rev. Rul. 71-52, but until it changed that ruling, it was extending payroll and withholding exemptions to ISOs and disqualifying dispositions of statutory option stocks. Because of the similarities between these options and ESPPs, employers assumed ESPPs received similar favorable tax treatment.

Guidance in 2001

In February 2001, the IRS issued Notice 2001-14, indicating that Rev. Rul. 71-52 was obsolete and did not apply to statutory option exercises, and that Notice 87-49 was no longer applicable. The Service indicated it would issue guidance to clarify the application of income, FICA and FUTA tax withholding on ISOs and ESPPs. In the interim, employers are not required to withhold taxes for options exercised before 2003.

In November 2001, the IRS issued updated guidance as proposed regulations under Secs. 3121, 3306 and 6041. In addition, it issued Notice 2001-72, requiring taxpayers to report obligations on "disqualifying dispositions" of stock received from the exercise of statutory stock options, and Notice 2001-73, referring to the imposition of FICA and FUTA taxes.

The proposed regulations subject both ISOs and options granted under an ESPP to employment taxes. An employer incurs FICA and FUTA tax obligations when an individual exercises the options (which can prove to be an administrative nightmare). The amount subject to taxation is equal to the "spread" at exercise, the difference between the stock's fair market value at exercise and the option's exercise price. The Service does not require the employer to withhold income taxes when the individual exercises the statutory options, because they are not subject to income tax as a result of an exercise (unless the individual disposes of the shares at that time).

Under Notice 2001-72, no income tax withholding would be required on a disqualifying or other disposition of stock acquired through the exercise of a statutory stock option. However, compensation income resulting from the disqualifying disposition of shares acquired from ISO and ESPP exercises would need to be reported on an employee's W-2. Employers would have to make reasonable efforts to determine whether they are required to provide a Form W-2 to their employees.

In Notice 2001-73, the IRS proposed several rules of administrative convenience to facilitate payment of the employee portion of FICA and FUTA taxes that result from the exercise of a statutory option. Employers could treat income derived from option exercises as occurring over one or more pay periods, rather than on the actual payment date. They could then report the income on a quarterly, semi-annual or annual basis, as long as all taxes are paid by December 31st of the year of exercise. The employer can change its accounting method at any time without the Service's approval, but must apply the rule consistently among all its employees.

The IRS will also allow income resulting from option exercises in December to be treated as being paid in the first quarter of the following calendar year. Employers must apply the rule to all employees. This choice would also bind the employee, and the employer will have to notify the employee of this treatment. Lastly, an employer may allow employees to pre-fund their FICA tax obligation, or may advance the funds necessary to pay the FICA tax arising from option exercises.

The rules of administrative convenience in Notice 2001-73 are intended to help employers and employees meet their employment tax obligation that results from exercising statutory stock options. The income tax treatment of outstanding options would not be affected if the IRS adopts the rules.

The proposed regulations will not apply to statutory stock options exercised before 2003, and will not be effective until the Service publishes final regulations. However, employers can voluntarily elect to apply the final regulations to statutory stock options exercised before 2003.

From Derrick P. Neuhauser, J.D., Atlanta, GA, and James R. Blinka, CPA, MST, Milwaukee, WI