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Application of employment taxes to statutory stock options.

In February 2001, the IRS issued Notice 2001-14, Application of Employment Taxes to Statutory Stock Options, which made Rev. Rul. 71-52 obsolete. Notice 2001-14 clarifies the issue of the assessment and collection of FICA, FUTA and income tax withholding on statutory stock options, which include both incentive stock options (ISOs) and employee stock purchase plans (ESPPs), covered under Secs. 422(b) and 423(b).

Under the notice's interim guidance, the Service will not assess FICA or FUTA tax on the exercise of an option and will not treat a disqualifying disposition of the stock acquired through exercise of statutory stock options as subject to income tax withholding, for those options exercised through Jan. 1, 2003. However, the interim guidance does not relieve individual taxpayers of the obligation to include any compensation in income on a disqualifying disposition of stock acquired pursuant to the exercise of a statutory option.

In Rev. Rul. 71-52, the IRS determined that an employer did not make a payment of wages for purposes of assessing employment or income tax withholding at the time of the exercise of the qualified stock options under former Sec. 422. The ruling also held that the disqualifying disposition of stock acquired by exercise of qualified stock options did not result in wages for Federal employment tax and income tax purposes.

Over a decade later, the Service issued Notice 87-49, which addressed the inconsistencies between the proposed regulations under Secs. 83 and 422, and Rev. Rul. 71-52. Because of changes in the Tax Reform Act of 1996, the IRS issued Regs. Sec. 1.422A-1(b), which provided that Regs. Sec. 1.83-6 governed the effects of a disqualifying disposition, Regs. Sec. 1.83-6(a)(2) holds that an employer is only allowed a deduction under Sec: 83(h) if it withholds income tax under Sec. 3402. This conflicts directly with Rev. Rul. 71-52. In Notice 87-49, the Service admitted the conflict and backed off on requiring companies to withhold as a condition for a deduction under Sec. 83(h). However, the IRS also indicated Rev. Rul. 71-52 was being reconsidered and that only on a prospective basis, income from such a disqualifying disposition was subject to withholding of employment taxes.

Little had changed in this area until the Service acquiesced in Sun Microsystems, Inc., TC Memo 1995-69, in which the Tax Court rejected the IRS's positions in Rev. Rul. 71-52 and Notice 87-49, and held that the income spread on the disqualifying disposition of ISO shares was in fact wages under Sec. 3401(a).

With this decision in mind, the Service cited Sun Microsystems and held in Field Service Advice (FSA) 9926034 that the exercise of ESPP stock constituted wages subject to FICA withholding. The FSA did not address disqualifying dispositions of ESPP shares; presumably, it would argue that Sun Microsystems would also govern such dispositions.

Currently, neither the Code nor relevant regulations contain any provision excluding the value of stock transferred pursuant to the exercise of a statutory stock option from wages for employment and income tax withholding purposes.

The overall concern is that the regulations, rulings and IRS actions suggest that any additional guidance issued will require employers to apply employment taxes to the compensation received on statutory stock options at the time of the exercise, rather than on the disqualifying disposition of stock acquired pursuant to a statutory option plan. Controversy on this issue arises because an employer issuing the options and the employees exercising the options are paying employment tax upfront on an intrinsic value of a stock, a value that it may never realize if the stock declines in price, as was the case in many recent dot-com situations.

With the issuance of Notice 2001-14, the Service in essence declares a moratorium on the assessment of employment tax and income tax withholding on the exercise of statutory stock options, and it will not treat the disqualifying disposition of stock acquired pursuant to an employee's exercise of a statutory option as subject to income tax withholding for those options exercised through Jan. 1, 2003, or until such time the legislation issues further guidance.

In practice, most employers are not withholding employment taxes on exercise of statutory options, and those that have could now apply for refunds. Employers and employees alike should carefully monitor further IRS pronouncements. Some employees may be tempted to exercise options by Dec. 31, 2002 to avoid FICA tax. Some employers may wish to give limited employee incentives to encourage such exercises.

It is likely, due to the confusion in this area, that many employers are not withholding income or FICA taxes on disqualifying dispositions of stock acquired through exercise of statutory stock options. Compliance with Notice 2001-14 will be burdensome, particularly in the case of disqualifying dispositions by former employees. The notice also raises questions about former employees who have become independent contractors. For example, should these individuals be paying self-employment taxes on disqualifying stock dispositions prior to 2003?

Practitioners hope that the Service will issue clarifying pronouncements or legislation well before January 2003.

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Article Details
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Author:Moore, Philip E.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Oct 1, 2001
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