Fringe benefit developments: stock options and qualified transportation fringes.

The Internal Revenue Service has been busy in recent weeks issuing guidance on several fringe benefit projects that were included in its 2000 Priority Guidance Plan. Included in the latest releases are Notice 2001-14, addressing the employment taxation of Incentive Stock Options (ISOs) and Employee Stock Purchase Plan (ESPP) options; Announcement 2001-7, postponing the earlier announcement requiring the segregated reporting of non-qualified stock option income on Forms W-2; and final regulations pertaining to qualified transportation fringe benefits. This article reviews these important developments.

Withholding on ISO and ESPP Option Income

After setting up dozens of proposed employment tax assessments and spending almost two years in the U.S. Court of Federal Claims defending a challenge to one such assessment in Micron Technology, Inc. v. United States, the Internal Revenue Service in mid-January issued Notice 2001-14,(1) which provides employment tax relief to employers with ISO plans and ESPPs. This Notice should allow taxpayers under audit and in Appeals on the issue of the proper employment taxation of ISOs and ESPPs to close out those cases on the basis of a full concession by the IRS. Those taxpayers who have been withholding employment taxes on ISOs and ESPP options should be entitled to refunds of the taxes paid for any open years.

ISOs and options granted under ESPPs do not generate option income to the employee when granted or exercised. Instead, at disposition of the stock received on exercise, compensation income may potentially be triggered. In Rev. Rul. 71-52,(2) the IRS concluded that neither the exercise of the statutory predecessors to ISOs and ESPP options, nor the disposition of the stock received on exercise of such options, resulted in wages subject to federal income tax withholding, FICA taxes, or FUTA taxes. The IRS in its private letter rulings applied the conclusions of Rev. Rul. 71-52 to ESPPs. And, consequently, taxpayers relied on Rev. Rul. 71-52 in concluding that employment taxes were not required to be withheld or paid in connection with the exercise of ISOs and ESPP options, or the disposition of the stock received on exercise of such options.

In Notice 87-49,(3) the IRS announced that it was reconsidering Rev. Rul. 71-52, but averred that it would apply Rev. Rul 71-52 to ISOs until further notice. Notice 87-49 was issued to address an issue in the proposed ISO regulations and had nothing to do with ESPPs. Nonetheless, the IRS subsequently reasoned that ESPPs might be treated differently from ISOs. The first the public heard of this distinction was in Private Letter Ruling 9243026 (June 24, 1992), in which the IRS concluded that FICA and FUTA taxes applied at the time of the ESPP option exercise to the difference between the fair market value of the stock and the exercise price and, further, that federal income tax withholding applied to the income on disqualifying disposition.

After PLR 9243026, the IRS focused in its employment tax audits on the employment tax treatment of ESPPs. Dozens of taxpayers received proposed assessments during such audits. The proposed assessments impose FICA taxes on the exercise of ESPP options and federal income tax withholding on disqualifying disposition of ESPP stock. Beginning in 1997, the IRS also audited ISO plans using the Tax Court's opinion in Sun Microsystems v. Commissioner(4) as ammunition. Sun Microsystems held that disqualifying disposition income qualified as wages for purposes of the research credit. One taxpayer, Micron Technology, Inc., challenged the IRS's position in the U.S. Court of Federal Claims. The other cases generally have been held in suspension at the audit or Appeals level pending the outcome of the Micron litigation.

Notice 2001-14 announces the end of this controversy -- at least for the back years and for the future through January 1, 2003. Specifically, with respect to ISOs and ESPP options exercised on or after publication of the notice and before January 1, 2003, the IRS will not assess FICA or FUTA taxes on exercise or require income tax withholding at disqualifying disposition. For exercises occurring before publication of Notice 2001-14, the employer may choose to apply this relief. Thus, Notice 2001-14 should permit taxpayers to resolve all ongoing audit and administrative appeals activity on this issue on the basis of a full concession by the government.

In addition, the IRS will honor otherwise allowable claims for refund of any FICA or FUTA taxes paid. Employers who have been withholding and paying FICA and FUTA taxes in connection with ISOs and ESPPs should file refund claims covering both the employee and employer shares of FICA taxes for all open years. The statute of limitations for claims with respect to FICA taxes and federal income tax withholding for 1997 expires April 15, 2001, unless it has otherwise been extended. Taxpayers should take care to file those claims on time and follow the special procedures in Treas. Reg. [sections] 31.6402(a)-2(a)(2) in order to obtain a refund of the employee share of FICA taxes, as well as the employer share.

In addition to resolving the controversy for back years (and the future through January 1, 2003), Notice 2001-14 declares Rev. Rul. 71-52 obsolete. The Notice concedes that the IRS administrative guidance on the issue has been unclear. The IRS anticipates issuing clarifying guidance by January 1, 2003, that will on a prospective basis require that FICA and FUTA taxes be withheld and paid on exercise of ISOs and ESPP options. The Notice also states that the IRS is considering treating amounts realized upon disposition of ISO and ESPP stock as not subject to income tax withholding.

Employers should consider commenting on the anticipated guidance because there is a serious question whether IRS guidance requiring the imposition of FICA taxes on exercise of ISOs and ESPP options would be statutori]y authorized. As taxpayers have been arguing at the audit and appeals levels, and as Micron has been arguing in court, at exercise of these options, there is no income. The courts have agreed with employers that FICA taxes cannot be imposed where there is no income.(5) Since there is no income at exercise, the holding of the cases is that there cannot be FICA and FUTA taxes. With respect to dispositions of ISO and ESPP stock, there are issues of administrative feasibility associated with federal income tax withholding, as the IRS recognizes in Notice 2001-14. Moreover, there are statutory obstacles to the income tax withholding because the employer does not make a payment at the time of the employee's disposition of the stock. It is the employee that has control over the disposition of the stock and, consequently, the payment of the compensation. There may be a unique opportunity to convince the Treasury Department that the IRS cannot and should not require the imposition of FICA and FUTA taxes at exercise or the withholding of income taxes at disposition.

Segregated Reporting of Nonqualified Stock Option Income on Form W-2

On November 15, 2000, the IRS issued Announcement 2000-97,(6) requiring segregated reporting of nonqualified stock option income on Form W-2 beginning with calendar year 2001.(7) This requirement to report nonqualified stock option income on a segregated basis applies in addition to the longstanding requirement that such income must be included in the "total wages" reported in Box 1 of the Form W-2. Although the Treasury Department has declined to explain its reasons for requiring this new information reporting, taxpayers have expressed concern that the data might be used to support proposals to change the taxation of stock option income. Bills have been proposed in the past, for example, to mandate that stock options be subject to identical tax and accounting treatment. Moreover, if this Form W-2 reporting requirement were extended to ISOs and ESPPs, it might be used to collect data on the potential revenue gain from imposing FICA taxes on the exercise of these options.

Numerous representatives from the payroll reporting community immediately pointed out in comments to the Commissioner that the new reporting requirement: (a) has no statutory or regulatory support; (b) will impose substantial administrative costs on employers and payroll service providers; and (c) was issued without sufficient time for the payroll reporting community to comment on the requirement. In response to these concerns, on December 20, 2000, the IRS issued Announcement 2001-7,(8) making the segregated reporting of nonqualified stock option income "optional" for the 2001 Forms W-2.

Notwithstanding the optional nature of the segregated reporting of nonqualified stock option income for 2001, concern that the requirement lacks statutory or regulatory support remains, because the IRS has decided to make the reporting mandatory for 2002. All of the information currently collected on Form W-2 is issued under the authority of either statutory provisions or U.S. Treasury regulations, including section 6051 of the Internal Revenue Code, which requires every employer to issue annual written statements to (and about) each of its employees, and numerous regulations thereunder governing the form, manner and extent of the data that will be required on such annual statements. The absence of statutory or regulatory support for Announcement 2000-97's mandate to require reporting of nonqualified stock option income in an additional box on Form W-2 will place all employers in a very difficult reporting position, if the requirement is not rescinded. If an employer refuses to report and is later deemed by the IRS on audit to have issued incorrect information returns by not complying with Announcement 2000-97, the employer may be subject to penalties of $50 per form. In addition, the IRS has indicated that the employer's tax deduction for compensation attributable to the nonqualified stock option income will be denied. Thus, if this reporting proposal is not rescinded before 2002, employers will be left with two choices: (1) complying with what appears to be an unauthorized attempt to collect data on Form W-2 or (2) refusing to comply with the Announcement and facing the potential future information reporting penalties and the possible loss of compensation deductions. An opportunity exists, however, for taxpayers and the information reporting community to convince the Treasury Department that segregated reporting of stock option income is an additional burden that should not be imposed.

Qualified Transportation Fringe Benefits

The final regulations under section 132(f) of the Code essentially adopt the guidance set forth in the proposed regulations and retain the same question-and-answer format of the earlier guidance.(9) Generally applicable for taxable years beginning after December 31, 2001, the final regulations did make several significant changes worth highlighting, because they will affect how employers administer their qualified transportation fringe benefit plans.

Advance Distribution of Transit Passes. Treas. Reg. [sections] 1.132-9, Q/A-9 ("Q/A-__"), which explains how to calculate the monthly limitation on the excludability of qualified transportation fringes, has been expanded to permit the distribution of transit passes up to 12 months in advance, subject to the applicable monthly limitation and the following rules (which include an astounding exemption from employment taxes in certain situations).(10)

First, if the transit passes are distributed for a period of no more than three months and the employee is net scheduled to terminate employment before the beginning of the last month in the period, but does in fact terminate, the value of the transit passes provided for months beginning after the date of termination may be excluded from wages for employment tax purposes (FICA, FUTA, and income tax withholding), but must be included in the employee's gross income for reporting purposes.(11) In contrast, if at the time the three months' worth of transit passes are distributed in advance, the employee is scheduled to terminate before the beginning of the last month and does in fact terminate, the value of the transit passes for months beginning after the date of termination must be subjected to employment taxes.(12)

Finally, if the transit passes are distributed in advance for more than three months, the value of any passes provided for months during which the employee is not employed by the employer must be included in wages for employment tax purposes, regardless of whether there was an established date of termination of employment at the time of the advance distribution.(13) Thus, unless the employer has the procedural capability to trigger employment taxation of transit passes retained by employees for any months following an unscheduled termination, it should not distribute transit passes more than three months in advance.

Timing of Salary Reduction Elections. The final regulations are more generous in their interpretation of the timing of a salary reduction election than the proposed regulations. In Example 2 of Q/A-14(e) of the proposed regulations, the employee elected on February 27 to reduce his compensation payable on March 1 by $195 in exchange for a mass transit voucher (based on an applicable monthly limit of $65) to be provided in March (for the first calendar quarter of the year). The employee had been hired in January of that year. The example in the proposed regulations concludes that $130 of the value of the transit pass must be included in the employee's wages, because the compensation reduction election failed to "relate to qualified transportation fringes to be provided for a future period to the extent the election relates to $65 worth of transit passes for each of January and February of the year."

In the final regulations, the employee making an election on February 27 under the same fact pattern is not taxed on the value of the transit pass for February, even though the election was made on the next to last day of that month. According to Example 2 of Q/A-14(e), "[t]he $65 for February is not taxable because the election was for a future period that includes at least one day in February." Thus, the IRS (by permitting employees to make salary reduction elections one day before a scheduled payment of compensation) has created, without explanation, a rule for qualified transportation fringe benefit plans that is far more liberal than the rules for salary reduction elections and bonus deferral elections in any other contexts, which require elections to be made in the calendar year before the services are performed for which the compensation will be paid.

Substantiation of Expenses. In the case of cash reimbursements, the employer must implement reasonable procedures for ensuring that an amount equal to the reimbursement was incurred for qualified transportation expenses. The final regulations provide that when employee certification is a reasonable cash reimbursement procedure (e.g., when receipts are not provided in the ordinary course of business), the certification cannot occur in advance of the expense. Thus, employees will no longer be permitted to present an unused transit pass at the beginning of the month and certify to the employer that it will be used during the month for commuting.(14) In addition, the employee is no longer specifically required to certify that he or she actually used the transit pass (as opposed to letting a friend or family member use the pass), even though that requirement had appeared in the proposed regulations.(15)

In addition, in contrast to the proposed regulations, the final regulations adopt a time limitation -- albeit a generous one -- for requesting a cash reimbursement. Q/ A-16(c) provides that an expense substantiated within 180 days after being incurred will be treated as having been substantiated within a reasonable period of time. Like the "accountable plan" rules of section 62(c) of the Code, the reimbursement may be made in a subsequent calendar year provided the expense is substantiated within a reasonable period of time, not exceeding 180 days.

Limitation on Cash Reimbursements of Transit Passes. In the case of transit benefits, an employer cannot treat a cash reimbursement as a qualified transportation benefit, if a voucher or similar item exchangeable only for a transit pass is "readily available" for direct distribution by the employer to its employees. A voucher or similar item is readily available if an employer can obtain it from a voucher provider without incurring significant administrative costs and on terms no less favorable than those offered to individual employees.(16) The proposed regulations had adopted a "one-percent safe harbor" test as a means of determining whether there were significant administrative costs. Even though many commentators, representing both employers and transit operators, vigorously urged the IRS to revise this test, the agency has retained it with certain clarifications.

First, as proposed in the earlier regulations, administrative costs relate only to fees paid to fare media providers. Administrative costs are treated as "significant" if the average monthly administrative costs incurred by the employer for the voucher (disregarding delivery charges imposed by the fare media provider to the extent not in excess of $15 per order) are more than one percent of the average monthly value of the vouchers for a system.(17) Only voucher provider fees may be considered in determining availability; therefore, the employer's internal administrative costs are not included in the determination. As explained by the Preamble to the final regulations, "the test considering only voucher provider fees is a comparatively simple bright line test," whereas "[a] test that depends on the employer's internal administrative cost would necessarily be complex."(18) Because only voucher provider fees will be considered in determining availability, the IRS has delayed the application of the one-percent test to years beginning after December 31, 2003.(19)

The IRS did address employers concerns that other nonfinancial restrictions should be considered when determining whether vouchers are readily available. These would include restrictions imposed by voucher providers (other than fare media charges) that effectively prevent the employer from obtaining vouchers appropriate for distribution to employees. For example, vouchers would not be readily available if they were not available for purchase at reasonable intervals or were not provided within a reasonable period after being purchase. Likewise, if a voucher provider does not provide vouchers in reasonably appropriate quantities or in reasonably appropriate denominations, they may not be readily available.(20)

Parking. The final regulations confirm that qualified parking does not include any reimbursement for parking that would otherwise be excludable under section 62(c) of the Code as an amount paid under an accountable plan or as in-kind parking that would be excludable as a working condition fringe under section 132(d) of the Code. In explaining the application of those exclusions, the Preamble helpfully points out that the determination of their application depends on deductibility under section 162(a) of the Code and, moreover, that Rev. Rul. 99-7(21) addresses the circumstances under which daily transportation expenses, including parking, incurred by a taxpayer in going between home and a temporary work location are deductible under section 162(a).(22)

Conclusion

The Treasury Department has not issued its Priority Guidance Plan for 2001. This procedure for releasing, at the beginning of each year, a list of specifically identified areas in which regulations and other administrative guidance should be issued was developed during the first Clinton Administration. Therefore, if a Priority Guidance Plan is even released for 2001, it will be interesting to see which fringe benefit projects the Bush Administration has identified as worthy of the allocation of Treasury and IRS resources.

(1) 2001-6 I.R.B. 516 (Feb. 5, 2001).

(2) 1971-1 C.B. 278.

(3) 1987-2 C.B. 355.

(4) T.C. Memo. 1995-69.

(5) See Gerbec v. United States, 164 F.3d 1015 (6th Cir. 1999); Dotson v. United States, 87 F.3d 682,689 (5th Cir. 1996); Redfield v. Insurance Co. of North America, 940 F.2d 542, 548 (9th Cir. 1991); Anderson v. United States, 929 F.2d 648, 654 (Fed. Cir. 1991).

(6) 2000-48 I.R.B. 557.

(7) Because an employee, upon termination of employment (or a former employee upon exercising a stock option), may ask an employer to issue a Form W-2 at any time during the calendar year, any Form W-2 system changes for 2001 Forms W-2 had to be in place by January 1, 2001.

(8) 2001-3 I.R.B. 357.

(9) See 66 Fed. Reg. 2241 (January 11, 2001) and 65 Fed. Reg. 4388 (January 27, 2000), respectively. See also Mary B. Hevener and Mariana G. Dyson, "Easy New Payroll Tax Savings from Employee-Paid Parking and Transit Benefits," 52 The Tax Executive 115 (March-April 2000), for a detailed discussion of the proposed regulations issued in January 2000.

(10) Q/A-9(b).

(11) Q/A-9(c) and Q/A-9(d), Ex. 4. In other words, the value of the transit passes for any months following termination must be included in the employee's Box 1 wages on Form W-2, but do not need to be subjected to employment taxes.

(12) Id.

(13) Q/A-9(c) and Q/A-9(d), Ex. 5.

(14) Compare Q/A-16(d)(2) of the final regulations with Q/A-16(d)(2) of the proposed regulations.

(15) Id.

(16) Q/A-16(b).

(17) Q/A-16(b)(5).

(18) 66 Fed. Reg. at 2242.

(19) Q/A-25(b).

(20) Q/A-16(b)(6).

(21) 1999-1 C.B. 361.

(22) 66 Fed. Reg. at 2243. The Preamble does not warn employers, however, that Rev. Rul. 99-7 changed the definition of temporary work location to import the one-year rule from section 162(a) of the Code, resulting in a standard more confusing to apply than the previous standard that a temporary work location was any location at which the taxpayer performed services on an irregular or short-term basis, such as a matter of days or weeks. The best evidence of that confusion is found in the number of inquiries that IRS National Office has received from its own field offices. See Chief Counsel Advice Memoranda 200018052 (March 10, 2000), 200025052 (April 26, 2000), 200026025 (May 31, 2000), and 200027047 (May 10, 2000).

MARIANNA G. DYSON is a partner with Baker & McKenzie in Washington, D.C. She formerly served as Special Assistant for Fringe Benefits in the IRS Office of Associate Chief Counsel (EBEO). She is a graduate of the University of Louisville and the Georgetown University Law Center.

ANNE G. BATTER is tax counsel at Baker & McKenzie in Washington, D.C. She formerly served as a Senior Attorney Advisor in the IRS Office of Assistant Chief Counsel (IT&A) and as a law clerk to the Honorable Arnold Raum, U.S. Tax Court. She is a graduate of the University of Maryland and Harvard Law School.