Last year, the Internal Revenue Service issued proposed regulations that would change current law by imposing a social security tax and an unemployment tax at the time the employee exercises a statutory stock option. Although the proposed regulations were to take effect beginning Jan. 1, 2003, the IRS recently announced that it will delay the imposition of social security and unemployment taxes for at least two years following the date the IRS issues the final regulations on this issue.
An employer’s grant of stock options provides the employee with the opportunity to buy shares of employer stock at a set price (typically, at a reduced price) within a finite period of time. A statutory stock option can be either an Incentive Stock Option (ISO) or an option granted pursuant to an Employee Stock Purchase Plan (ESPP). Both of these arrangements receive special tax treatment under the Internal Revenue Code. One of the advantages of statutory stock options is that, under current law, there are no tax consequences for the employee or the employer upon the receipt of a statutory stock option or upon the exercise of a statutory stock option. Instead, the options are taxed when the employee ultimately disposes of the stock (i.e., at the time the stock is sold, gifted, or legal title is transferred, etc.).
For example, assume an employer grants an employee an ISO for twenty dollars ($20). At a later date, when the fair market value of the stock rises to fifty dollars ($50), the employee exercises the option and purchases employer stock. The difference between the strike price (the exercise price) and the value of the stock at exercise is often referred to as the spread. The IRS proposed regulations (if finalized) would now characterize the $30 spread as "wages" for purposes of imposing two types of tax. The first tax, a social security tax, applies pursuant to the Federal Insurance Contributions Act (FICA) and assesses a 7.65% tax on both the employer and the employee. The second tax, an unemployment tax, applies pursuant to the Federal Unemployment Tax Act (FUTA) and assesses an additional 6.2% tax on the employer. Traditionally, neither of these taxes would apply at this time.
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Once the proposed regulations were issued, the IRS received numerous comments from concerned employers and tax practitioners. In particular, employers were concerned about the administrative burdens they would incur in their efforts to accurately and timely withhold FICA and FUTA taxes starting in 2003. In response to these concerns, the IRS issued additional guidance in attempt to provide employers with workable methods of administering the employee’s portion of the FICA tax.
IRS Notice 2001-73 sets forth three administrative options to employers.
Under the first option, the employer could treat the wages upon exercise of a statutory stock option as if the wages were paid over one or more periods within the calendar year. Generally, the guidance requires that the taxes must be paid by December 31st of the calendar year in which the option is exercised. If an employee exercised a statutory stock option in December, a special accounting rule would permit the employer to treat the amount of wages upon exercise as if they were paid in the first quarter of the next following calendar year. Under the second option, the employer would be permitted to reach an agreement with the employee in which the employee could agree to pre-fund the employee’s portion of the FICA tax due. The third option would permit the employer to reach an agreement with the employee whereby the employer would pay the employee’s portion of the FICA tax upon the condition that the employer was able to seek reimbursement from the employee at a later time.
Whatever option the employer selected, the employer would be required to apply the option to all employees.Even with this new guidance, criticism surrounded the proposed regulations. In direct response, the IRS announced, in Notice 2002-47, that it will not assess FICA nor FUTA taxes on the exercise of statutory stock options until at least two years following the date the final regulations are released. The IRS statement suggests that the IRS intends to re-examine these issues. It is likely that the IRS will maintain its current position and impose FICA and FUTA taxes on the exercise of statutory stock options. The possibility for the alternative, however, is left open by the delay. At a minimum, the delay will provide employers more time to establish compliance procedures prior to the effective date of these new requests.
Tracy A. Vitols is an associate in the Corporate / Employee Benefits Practice Group of Hinckley, Allen & Snyder LLP.
