ISO payments.

Are FICA and health insurance tax required on the disqualified disposition of an incentive stock option (ISO)?

Sec. 421(a) provides that, in general, there is no income recognition at the time of the transfer of stock to an individual who exercises an option, and no deduction is allowed to the employer, if the requirements of Sec. 422(a) are met. Sec. 422(a) provides, in part, that Sec. 421 (a) shall apply to the exercise of an ISO if (1) no disposition of such share is made within two years from the date of granting the option nor within one year after the transfer of such shares and (2) at all times during the period beginning on the date of granting the option and ending on the day three months before the date of exercise, such individual was an employee of the corporation.

Sec. 421(b) states that a"disqualifying disposition" will occur if the transfer of stock pursuant to the exercise of an option would otherwise meet the requirements of Sec. 422(a) except when there is a failure to meet the holding period requirements, e.g., if the stock is sold within one year of the date of exercise of the ISO, or within two years of the grant of the option. As a result, the increase in such individual's income for the year in which the disqualifying disposition occurred shall be treated as compensation income and the employer corporation may take a deduction equal to the amount of income recognized by the individual. This means that in the event of a disqualifying disposition of an ISO, the income recognized by the individual is treated as "compensation" (i.e., ordinary income instead of short-term capital gain), and the company is allowed a deduction for the amount of income recognized by the employee.

For a company to obtain the deduction produced by the disqualifying disposition, the amounts must be reported on a Form W-2 or 1099. In the case of such a disposition, a Form W-2 or W-2c will be considered timely if it is furnished to the employee or former employee and filed with the Federal government on or before the date on which the employer files its tax return (including an amended return) claiming a deduction for that amount.

Under Rev. Rul. 71-52, the income as a result of a disqualifying disposition of an ISO was not subject to either FICA or FUTA taxes. In addition, if the person was an employee, or was an employee during the year, the amount of ordinary income that should be reported by the taxpayer should be included on the employee's W-2 as "other compensation," although there is no withholding required to obtain the deduction. If the person exercising an ISO is a former employee and is not getting a W-2 for the current year, the income should be reported on a Form 1099. In any event, upon the exercise of an ISO, the company should send, by January 31 of each year, for the preceding year, a statement containing information about the exercise and the cost of the shares. If the options are nonqualified options and not ISOs, a different conclusion would be reached and FICA and payroll withholding should be reported.

Is withholding required when the options are exercised after the employee had not been employed by the company within the three-month period required by Sec. 422(a)? And what are the consequences if an employee receives pay that would be reported on a W-2 in accordance with a severance agreement?

For a disposition after the three-month requirement had ended, FICA should be withheld. This conclusion was reached after a review of the relevant Internal Revenue Code sections. It appears that this specific question is not addressed, so the general rules of Sec. 83 regarding compensation for property transferred in connection with services were applied.