TEI comments on nonqualified stock options: June 9, 2003.

On June 9, 2003, the Institute submitted the following comments to the Department of the Treasury and Internal Revenue Service requesting updated guidance on the rules governing employment and withholding tax deposits relating to the exercise of nonqualified stock options. The comments, which took the form of a letter from TEI President J.A. (Drew) Glennie, were prepared under the aegis of TEI's Federal Tax Committee, whose chair is Mitchell S. Trager of Georgia-Pacific Corporation. Contributing substantially to the development of TEI's comments were Michael S. Nesbitt of Paychex, Inc., chair of TEI's Subcommittee on Benefits and Payroll Taxes, and Neil D. Traubenberg of Storage Technology Corporation.

In related action, TEI President Drew Glennie submitted a letter to the Commissioner of the Large and Mid-Size Business Division, Deborah M. Nolan, commending LMSB for issuing the Field Directive of March 14, 2003, limiting the application of the penalty for failure to timely deposit withholding taxes on the exercise of nonqualified stock options. The two-page letter can be obtained by contacting TEI Washington.

On behalf of Tax Executives Institute, Inc., I am writing to request the issuance of guidance clarifying when income tax withholding and employment tax deposits are due following the exercise of nonqualified stock options (NQSOs). During liaison meetings with the IRS Large and Mid-Size Business (LMSB) Division and the Treasury Department, TEI noted that IRS examiners were asserting or threatening assertion of penalties against employers for failing to timely deposit employment and income tax liabilities where such amounts exceeded $100,000 and were not deposited by the day after the exercise of the NQSOs. TEI said that there is a lack of clear guidance in respect of the date wages are considered paid upon the exercise of NQSOs, engendering confusion for taxpayers. In the absence of clear guidance, it would be inequitable for the IRS to assert the penalties. As important, it would be burdensome for employers to timely comply with a stringent interpretation of the "next-day" deposit rule--especially those subject to the semiweekly deposit schedule--upon exercise of NQSOs. The LMSB and Treasury Department representatives invited TEI to submit comments elaborating on its concerns and recommendations, especially in respect of whether rules of administrative convenience would enhance compliance.

Subsequently, in a Field Directive dated March 14, 2003, IRS examiners were instructed, solely for penalty purposes, not to challenge the timeliness of employment and withholding tax deposits exceeding $100,000 that arise from the exercise of the stock options, as long as the deposits are made within one day of the settlement date of the option. TEI commends LMSB for issuing the Field Directive, but we believe that more up-to-date guidance and more administrable rules governing the timing of tax deposits in respect of the exercise of NQSOs should be provided to employers. Since most NQSO plans are administered through stock brokers and the cash for the exercise price and employment and withholding taxes is not available to the employer on the date of exercise, we urge the IRS and Treasury Department to issue rules of administrative convenience for FICA, FUTA, and income tax withholding related to NQSO exercises that are similar to those set forth in Notice 2001-73. We suggest that employers be permitted to make the requisite tax deposits within a reasonable period of time following an NQSO's settlement date. A reasonable period of time for making the deposit following the employer's receipt of notice from the broker that an option has been exercised would, at a minimum, be no earlier than the deposit date for the employer's next regularly scheduled payroll processing period for "cash" wages. TEI is pleased to provide the following comments and elaborate on our recommendations.

Tax Executives Institute

Tax Executives Institute is the preeminent association of business tax executives in North America. Our more than 5,300 members represent 2,800 of the leading corporations in the United States, Canada, and Europe. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises, including the employment and withholding tax deposit rules applicable to compensation. In addition, since most members' companies grant nonqualified stock options to their employees, members must advise their companies on the associated employment and withholding tax liabilities that arise from the exercise of NQSOs. The diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to these issues.

Overview of Current Rules and TEI's Recommendation

Upon exercise of a nonqualified stock option (NQSO), an employee receives income from wages that is subject to withholding for federal income, social security (Federal Insurance Contribution Act or FICA) taxes, and Medicare taxes, as well as for state and local income taxes. Correspondingly, the employer is obligated to pay its share of applicable FICA and Medicare (and possibly Federal Unemployment Tax Act or FUTA) taxes for the wage income. TEI does not question whether the taxes are owed by either the employer or the employee. Rather, the questions are when the employment and withholding tax deposits should be made in order to be considered timely and whether the deposit rules are administrable. To be administrable, the rules governing the timing of the tax deposits must afford employers sufficient time to accumulate and process the requisite information and make timely deposits. Moreover, administrable rules should not impose undue burdens by compelling employers to process and update their payroll records every date an NQSO is exercised, which under the next-day deposit rule could be every day the stock market is open.

The IRS has issued one ruling that addresses the employment tax treatment of option exercises. (1) Rev. Rul. 67-257, however, predates the enactment of section 83 of the Code and arguably became obsolete upon the section's enactment. More important, although the ruling likely reflected common practice in 1967, it does not reflect current employer compensation policies and stock plan administrative practices. Specifically, most stock option plans today cover a much broader range of employees than was the case in 1967. In addition, the FICA and Medicare wage base have expanded substantially. Thus, many more employees are subject to FICA and Medicare taxes in addition to federal (and state) income tax withholding as a result of option exercises. Correspondingly, stock options are exercised far more frequently, potentially subjecting employers to multiple payroll processing requirements and more frequent employment tax deposits if the exercise of the NQSO were to trigger the next-day deposit rule.

The 1967 ruling is also factually inapposite because it rests on the premise that employees tender cash or a check in payment of the option price and related tax liabilities upon the exercise of the option. Today, many, if not most, employer stock option plans are broker-assisted, an administrative feature that permits employees to exercise their stock options without obtaining a loan to pay the option price and related tax liabilities. In view of the changes in employer compensation and stock plan administrative practices, we urge the IRS and Treasury Department to (1) issue updated employment and withholding tax deposit guidance for NQSO exercises, including a rule of administrative convenience to govern the timeliness of the deposits and (2) if necessary, provide a window during which employers, brokers, payroll service providers, and stock transfer agents can modify their procedures to comply with new guidance.

Description of NQSO Exercises

When Rev. Rul. 67-257 was issued, most employers handled nearly all administrative aspects of their stock option plans in-house, including the payroll and stock-transfer functions. Today, many employers take advantage of the cost savings of specialization and outsource those functions to third-party service providers. In addition, most employers have broadened the scope and coverage of participation in stock option plans in order to better align employee and shareholder interests. Given the expanded number of participants as well as the desire of employers to address the cash-flow burden that withholding taxes and the option price impose on optionees, most stock option plans today are also administered with the assistance of stock brokers. Under such plans, companies often designate a broker of record to handle all option exercises, though in some cases employers may permit employees to use their own broker. By working with a broker, companies (and their affiliates) afford employees a choice among (1) exercising and holding the stock, (2) exercising and selling a portion of the stock in order to pay the exercise price or associated withholding taxes, or (3) exercising and selling all the stock.

The exercise of an option in a broker-assisted stock option plan involves a number of parties in addition to the employee and employer. The time involved in orchestrating the various steps in the option exercise is critical to understand why a stringent application of the "next-day" deposit rule is not administrable. In most cases, employees initiate the exercise of an NQSO by notifying the broker of a desire to exercise the option and, potentially, sell all or part of the stock acquired on exercise. The broker, in turn, notifies the employer who then instructs its stock transfer agent to issue stock in the name of the broker. In addition, the employer will direct the broker to provide the stock transfer agent with delivery instructions. Upon receipt of the broker's instructions, the transfer agent will issue the option shares to a clearinghouse with directions to hold the employer's shares for the benefit of the broker. After the clearinghouse makes the shares available to the broker, the broker will credit the shares to the employee's account. The last step--the credit to the employee's account-generally occurs on the settlement date, i.e., three days after the exercise, but may occur later. (2)

In the meantime, the broker will provide information about the exercise to the employer's payroll department (or the employer's payroll service provider) and the stock administration department. Since the wage income arising from the exercise is the difference between the "fair market value" of the stock and the exercise price, the amount subject to income and employment taxes often cannot be determined (at the earliest) until the close of the market on the date of exercise. (3) Hence, the information from the broker, which would include an initial estimate of the payroll and federal and state income taxes to be withheld in connection with the option income, cannot be transmitted to the employer until very late in the day; indeed, depending on the arrangement between the broker and employer, the degree of automation of the information transfer between the two, and the number of employees who exercise options on a given day, the broker in most cases will not transmit the information to the employer until the next business day at the earliest. (4) Even the most advanced information transfer arrangements between brokers and employers involve batch file processing and few, if any, brokers or employers have the technology or other resources necessary to accelerate the data transfer to a real-time basis.

After the employer receives the broker's calculation of the wage income from the option exercise, the employer's payroll department will frequently make adjustments to the broker's withholding estimate in order to reflect the employee's facts and circumstances. For example, the employee's cumulative wages for the year may, either before or as a result of the exercise, exceed the social security wage base limit. If the employer makes adjustments to the broker's initial estimated tax withholding, the employer must relay the adjusted information back to the broker and update its employee's cumulative payroll data. Where the employer has outsourced the payroll function, the employer must relay the information to the payroll service provider in order to make the appropriate adjustments and return the updated data to the broker, thereby adding even more time to the cycle for the transfer of information. Regardless of whether the payroll is processed in house or by a service provider, the proper amount of withholding on the wage income arising from the options can be calculated and paid most efficiently and effectively by automatically processing it in the normal course of business with the employer's routine or "cash" wage payroll.

Where the employee sells some or all of the shares in order to pay the applicable withholding taxes or the option price, the broker will remit a portion of the proceeds to the employer. Depending on the arrangement between the employer and the broker, the time between the settlement date and the date the broker finally remits the funds to the employer for the option price and taxes can vary widely.

Finally, options are generally granted on the stock of a parent company. The employee, however, may work for an affiliate and the parent company that issues the stock must coordinate the various steps with the affiliate that employs the optionee and processes his or her payroll. Thus, additional delays may occur in the transfer of information among the affected parties.

In view of the multiple parties and steps involved in an NQSO exercise and the many factors that affect the transmission of information, employers frequently require several days after an employee initiates an option exercise to accumulate the data, process it, and deposit the proper amount of employment and withholding taxes.

Legal Background

Under Treas. Reg. [section] 31.3402(a)-1(b), employers are required to deduct and withhold income taxes "from the employees' wages as and when paid, either actually or constructively." (5) Consequently, the deposit requirements depend on an actual or constructive payment of wages. Under Treas. Reg. [section] [section] 31.6302-1(c)(1) and (2), employers are generally required to deposit employment taxes either on a monthly or a semi-weekly basis. Where an employer accumulates employment taxes of $100,000 on any day during a monthly or semi-weekly deposit period, Treas. Reg. [section] 31.6302-1(c)(3) requires that the taxes be deposited by the close of the next banking day--the so-called next-day deposit rule.

Under section 83 and the related regulations, the date on which beneficial ownership of stock that is subject to an option is transferred to the employee determines when the employee is subject to tax, the option spread (i.e., the difference between the stock's fair market value and the stock option price) is reported to the employee, and the amount of the employer's deduction is set. The employment tax and wage withholding rules, however, apply only when wages have been "actually or constructively paid" by the employer. (6) The regulations defining the withholding obligation for income, FICA, and FUTA tax purposes state, as follows:

   Wages are constructively
   paid when they are credited
   to the account of or set apart
   for an employee so that they
   may be drawn upon by him
   at any time although not
   then actually reduced to
   possession. To constitute
   payment in such a case the
   wages must be credited to
   or set apart for the employee
   without any substantial
   limitation or restriction as
   to the time or manner of
   payment or condition upon
   which payment is to be
   made, and must be made
   available to him so that
   they may be drawn upon at
   any time, and their payment
   brought within his
   own control and disposition.

TEI recommends that guidance be issued to clarify when the actual or constructive payment of wages occurs in the context of the exercise of a broker-assisted NQSO exercise. The LMSB Field Directive issued on March 14, 2003, acknowledges that there is a dispute about whether the exercise date or settlement date triggers the employer's withholding tax liability. It states--

   [w]hile I.R.C. Sec. 83 and the
   Regulations thereunder generally
   point to exercise date
   as the trigger for inclusion
   of income from exercise of
   nonqualified stock options,
   the FICA and income tax
   withholding provisions do
   not impose a withholding
   obligation on the employer
   until wages are actually or
   constructively paid. It has
   been argued that the shares
   (or the value of the shares)
   are not available to the exerciser
   of the options until
   settlement date, and therefore
   no actual or constructive
   payment of wages takes
   place until that time.

The Field Directive states that there is currently "no specific published guidance relative to whether the date of exercise or date of settlement is the appropriate date for considering assertion of the penalty for failure to deposit employment taxes attributable to the exercise of nonqualified stock options." As a result, "employment tax specialists should not challenge the timeliness of deposits required under Treas. Reg. [section] 31.6302-1(c), if such deposits are made within one day of the settlement date, as long as such settlement date does not fall more than three days from date of exercise." TEI submits that before the IRS can properly consider whether penalties are appropriate, the underlying substantive rules must be sufficiently clear to warrant consideration of penalties.

As important, regardless of whether the exercise or settlement date establishes the date of payment of wages to the employee (thereby triggering the employer's withholding and tax deposit obligations), a stringent application of the next-day deposit rule for stock option exercises would impose a costly, burdensome requirement on employers--a burden that some may not be able to comply with. (7) A fundamental prerequisite for complying with the next-day deposit rule is the employer's ability to predict with certainty when its liability will exceed the $100,000 threshold. For regularly scheduled "cash" payrolls--whether weekly, biweekly, semi-monthly, or monthly --employers control the time and amount of the wage payment and thus can easily predict and control when the next-day deposit liability threshold will be exceeded. On the other hand, employees control the date and amount of stock option exercises, and consequently, employers cannot predict when the next-day deposit threshold would be exceeded unless they compute and process a special payroll every business day that stock options are exercised. Requiring such special payrolls for every stock option exercise would be unreasonable, so the IRS and Treasury Department should establish rules of administrative convenience governing the timing of tax deposits for employment and withholding taxes arising from the exercise of NQSOs.

The IRS has adopted rules of administrative convenience permitting employment tax deposits to be made well after the date wages are actually or constructively paid. (8) Administrative rules of convenience are especially important where, as with an option exercise, the employer does not control the timing of the payment of the wages. Thus, the IRS recognized the need for rules of convenience when it proposed regulations imposing FICA and FUTA taxes on statutory option exercises. Under Notice 2001-73 employers may treat the FICA and FUTA wages arising from the exercise of a statutory option as though paid on a pay period, quarterly, semi-annual, annual, or other basis, as long as they were treated as paid on or before December 31 of the year of the exercise. (9) In addition, actual exercises occurring in December of a calendar year were permitted to be treated as though paid in the first calendar quarter of the next following calendar year.

TEI submits that the administrative issues that arise from the exercise of NQSOs are no different from--and no less difficult to comply with than--those faced by employers in connection with statutory option exercises. Indeed, in contrast with statutory options, which are generally exercised on prescribed dates, nonqualified options may be exercised at any time. As a result, the only way that employers can correctly compute their withholding deposits and comply with a next-day deposit rule is to process their payrolls on a daily basis. (10) This is impractical. Accordingly, we urge the IRS and Treasury Department to issue rules of administrative convenience for FICA, FUTA, and income tax withholding related to NQSO exercises that are similar to those set forth in Notice 2001-73. We suggest that employers be permitted to make the requisite tax deposits within a reasonable period of time following the settlement. A reasonable period of time for making the deposit following the employer's receipt of notice from the broker that an option has been exercised would, at a minimum, be no earlier than the deposit date for the employer's next regularly scheduled payroll processing period for "cash" wages. Such a rule would afford the employer sufficient time to efficiently process the compensation and withholding tax information as part of routine payroll processing, thereby saving considerable time and expense without unduly delaying the tax deposit.

To illustrate TEI's recommended minimum period, consider an example where an employer with a biweekly payroll period issues payroll checks that are dated one week after the end of the payroll period. Under this scenario, the employer's payroll period is from Day 1 to Day 14, with the payment to the employees occurring on Day 21. A second payroll period would run from Day 15 to Day 28, with payment occurring one week after Day 28. For most employers, the payroll for the payment on Day 21 would be processed between Day 15 and Day 20 in order to afford time for the payment to be made to the employee on Day 21. (11)

Assume an employee exercises an option on Day 15. The following day the employer receives notice of this exercise from the broker and the settlement occurs in the normal course by Day 18. Under TEI's recommendation, the employer would include the related payroll tax obligation with the payroll processed after the notice of exercise is received. In other words, the withholding obligation would be included in the payroll for the payroll period from Day 15 to Day 28. If the exercise occurred on Days 10 through Day 14 but the employer does not receive actual notice of the exercise before the end of Day 14, the employer should also be permitted to elect to include the withholding taxes in the deposit for the Day 15 to Day 28 pay period.

Guidance Should be Prospective

Any guidance provided should be prospective so that employers are provided with a period of time to change their procedures, if necessary, to comply with the new guidance. Treasury and the Service should not underestimate the time that will be needed in order for employers to work with their brokers, payroll processors, and software providers to come into compliance with any newly-issued guidance. Finally, the updated guidance should be no more stringent than the position set forth in the LMSB Field Directive.

Conclusion

Tax Executives Institute appreciates this opportunity to present its views on the need for guidance relating to deposits of employment and income tax withholding. The Institute's comments were prepared under the aegis of its Federal Tax Committee, whose chair is Mitchell S. Trager. If you have any questions, please do not hesitate to call Mr. Trager at 404.652.2690, or Jeffery P. Rasmussen of the Institute's professional staff at 202.638.5601.

(1) Rev. Rul. 67-257, 1967-2 C.B. 359.

(2) The settlement generally occurs three days after the exercise or trade date. Securities Exchange Act Rule 15c6-1(a), Settlement Cycle, states, as follows:

[A] broker or dealer shall not effect or enter into a contract for the purchase or sale of a security ... that provides for payment of funds and delivery of securities later than the third business day after the date of the contract unless otherwise expressly agreed to by the parties at the time of the transaction.

(3) Unless the stock is sold, many employers adopt a "fair market value" convention that utilizes a methodology that prevents determination of that value until the market closes on the day of exercise.

(4) Where an employer permits employees to use their personal broker (rather than a broker designated by the employer) for the exercise, there may be added delay in the transfer of the wage information.

(5) See also Treas. Reg. [section] [section] 31.3102-1(a) and 31.3121(a)-2(b).

(6) Treas. Reg. [section] [section] 31.3402(a)-1(b) (federal income tax withholding), 31.3121(a)-2(b) (FICA), and 31.3301-4 (FUTA).

(7) Employers depositing withholding taxes on a semiweekly basis would find it especially challenging to comply with a stringent application of the deposit rules. Several days may elapse between the employee's exercise of the option and the date the employer is able to calculate and deposit the proper amount of taxes. In many cases, the total elapsed time for the transfer of information from the broker to the employer may exceed the three-day option settlement period as well as the cut-off date for processing a timely deposit under the semiweekly deposit rules. Hence, rules of administrative convenience are especially important for employers that follow the semiweekly deposit schedules.

(8) For example, Notice 88-82, 1988-2 C.B. 398, permits employers to treat payments of group-term life insurance as though paid by the pay period, by the quarter, or on any other basis as long as the payments are treated as paid at least as often as once a year. Similar rules apply to other noncash fringe benefits.

(9) Notice 2001-73, 2001-2 C.B. 549.

(10) The statement assumes that the employer receives the information on the amount of wage income early enough in the business day to calculate the taxes and initiate a deposit transaction by the next day.

(11) The payroll process is not a simple one. It requires the employer to check and balance the gross to net amounts, reconciling the various deductions for each employee and in the aggregate. The cash transactions must then be processed to effect payment of the various liabilities. Entries must be recorded and management and financial reports produced for each business unit by payroll period and employee classification. Any "off-cycle" or special payroll period, such as a special computation undertaken solely to take account of NQSO exercises, will generally require manual intervention, which is time consuming and costly.