Publications

For the first time since the 1981 enactment of the incentive stock option (“ISO”) provisions in the Internal Revenue Code (“Code”), the IRS has published proposed regulations requiring the withholding of employment taxes upon the exercise of an incentive stock option, notwithstanding that such exercise does not result in the recognition of ordinary income tax.(1) According to the proposed regulations, the excess of the fair market value of the stock acquired pursuant to the exercise of an ISO over the amount paid for the stock constitutes wages for employment (but not income) tax purposes, and is subject to FICA withholding. But until these regulations are published in final form, the IRS will not assert FICA or FUTA tax upon the exercise of an ISO. In addition, the effective date of the proposed regulations is not until January 1, 2003. Thus, holders of ISOs who exercise ISOs on or before December 31, 2002 will not be subject to employment tax and during such time employers may continue to treat the exercise of an ISO as a nontaxable event for both income and employment tax purposes.(2) In addition, legislation has been proposed in Congress, supported by the head of the Ways and Means oversight subcommittee, that seeks to prevent the imposition of employment taxes upon the exercise of an ISO and thus nullify the proposed regulations. Until such legislation is passed or the IRS revokes the proposed regulations, however, employers as well as holders of ISOs should be aware of the potential employment tax liabilities beginning in 2003.

Background

If certain conditions are met, at the time stock is transferred to an individual pursuant to the exercise of an ISO, the Code specifically provides that no taxable income to the individual results upon such exercise. Instead, income is deferred until the sale or other disposition of the stock acquired pursuant to the exercise of a statutory option. The conditions required for such special tax treatment include a requirement that the individual not dispose of the stock within two years from the date of the grant of the option, that the individual not dispose of the stock within one year after the stock has been transferred to the individual pursuant to the individual’s exercise of the ISO, that the option price is not less than the fair market value of the stock at the time such option is granted and that such option by its terms is not exercisable after the expiration of 10 years from the date such option is granted.

For almost twenty years, the IRS applied the rule that that the exercise of an ISO did not have FICA, FUTA or income tax consequences. In January of 2001, however, the IRS reversed course and indicated in a public notice that while there was statutory authority in the Code which precluded the imposition of income tax on the exercise of an ISO, there was no similar provision precluding the imposition of FICA and FUTA tax. The IRS noted that because the social security system had objectives which were significantly different from the objectives underlying the income tax withholding rules, the amounts specifically exempted from income tax withholding should not be similarly exempt from FICA (and FUTA which follows FICA) unless Congress provides a specific tax exclusion. Unlike the exclusion from income tax upon the exercise of an ISO, there is no similar specific statutory exclusion from FICA and FUTA taxes.

Proposed Regulations

Following its receipt of comments, many of which contended that there was no statutory basis to impose FICA and FUTA tax upon the exercise of an ISO, the IRS promulgated proposed regulations in mid November 2001, which provide that at the time of the exercise of an ISO, the option holder receives wages for FICA and FUTA tax purposes and that the amount of such wages is the excess between the fair market value of the stock acquired pursuant to the exercise of the ISO, determined at the time of exercise, over the amount paid for the stock. The IRS also provided, however, that income tax withholding is not required when an individual exercises an ISO because of the specific exclusion from income under section 421(a) of the Code.

Example

Suppose Larry, an employee of the XYZ Company, is granted an ISO under the company’s plan. The ISO allows Larry to acquire 50 shares of XYZ Company stock, at an exercise price equal to the fair market value of the stock at the time the option is granted. At the time of the grant, the fair market value of the XYZ Company stock is $100 per share. Larry exercises his ISO at a subsequent date when the XYZ Company stock is valued at $120 per share. Thus, at the time of exercise, Larry acquires 50 shares of XYZ Company stock having a fair market value of $120 per share for $100 per share.

In this example, at the time of exercise, Larry has received wages for employment tax purposes equal to the excess of the fair market value of the stock ($120 per share) over the amount paid for the stock ($100 per share), or $20 per share for a total of $1,000. For FICA purposes, XYZ Company would be required to withhold $76.50 ($1,000 x 7.65 percent) in FICA tax.

As illustrated in the above example, while the employer would be required to withhold $76.50 in FICA tax, Larry would not have cash as a result of the exercise of the ISO to cover the withholding. One option would be for Larry to immediately sell some of the acquired stock to fund the employment tax obligations, but this would result in a disqualifying disposition of the shares sold, resulting in income tax liability to Larry at ordinary income tax rates. Understandably, the financial and administrative burdens stemming from the employment taxes imposed would make the use of ISO less attractive to employers and employees.

Employer Options for Withholding FICA Tax

Responding to such concerns, simultaneous with the issuance of the proposed regulations discussed above, the IRS issued Notice 2001-73 whereby it set forth proposed rules of administrative convenience for the payment of the employment tax liabilities resulting from the exercise of an ISO. Specifically, the IRS proposed four different scenarios in which the employment tax liability could be satisfied:

First, an employer could choose to treat the FICA and FUTA wages resulting from the exercise of an ISO as paid over more than one period or even as being paid on an annual basis. Thus, even though an employee may exercise an ISO in June of a particular year, the employer could treat the exercise for employment tax purposes as occurring on December 31 of the particular year. This, theoretically, would allow the employer to withhold from the employees wages a portion of the FICA tax on the exercise of the ISO over the remaining pay periods in the year of exercise.

Second, an employer would be permitted to choose to treat the wages resulting from the exercise of an ISO as occurring in the last month of a calendar year, or any shorter period ending on December 31, as paid in the first calendar quarter of the next following calendar year. This again could allow the employer and employee time to withhold from wages in future pay periods.

The third option provided is that an employer and employee could contractually arrange for the employee to pre-fund the amount of the employee portion of FICA tax that would arise upon the exercise of an ISO. Under this arrangement, any shortfall in funds to pay the employee portion of FICA is settled through withholding from the employee’s current compensation and any excess over the amount necessary to pay the employee portion of FICA tax is returned to the employee.

The fourth option is for the employer to advance the funds necessary to pay the employee portion of FICA tax and obtain reimbursement of those funds from the employee from further payroll deductions.

Rule of Consistency and Exclusion from Modification

Whichever option an employer chooses, the IRS states that it must apply the chosen rule consistently to all employees. In addition, the IRS set forth in the proposed regulations that the adoption of any of the above described four options and the application of such options to outstanding ISOs will not constitute a modification of such ISOs. As a result, the adoption of one of the four options will not cause the currently outstanding ISOs to be considered the grant of a new option, requiring a change in the exercise price and restart of the necessary holding periods.

Should you have any questions about the proposed regulations or IRS notice or how such regulations and notice affect the current outstanding ISOs (or options granted under an employee stock-purchase plan) you may have issued, or are currently holding, or the status of proposed legislation that would negate the regulation please call or e-mail: Peter H. Gruen at 203.498.4357 or [email protected] or Joseph A. SanFilippo at 203.498.4344 or [email protected].

Footnotes

(1) The proposed regulations also apply to the exercise of options under employee stock-purchase plans. For illustration and discussion purposes, this client advisory focuses on the application of the proposed regulations on the exercise of ISOs.

(2) The spread between the fair market value of the stock acquired upon exercise of an ISO and the exercise price is treated as a preference item for alternative minimum tax purposes, thus, the exercise of an ISO could subject the holder to alternative minimum tax