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IRS Issues New Stock Option Withholding And Reporting Rules
November 2001

Background. Earlier this year the Internal Revenue Service announced that it was reconsidering and would be issuing further guidance regarding the tax withholding and reporting rules that apply to shares of employer stock acquired under statutory stock option plans. Specifically, the IRS indicated that it was reviewing:

(1) The FICA (Social Security and Medicare) and FUTA (unemployment) tax consequences of exercises of incentive stock options ("ISOs") as defined in Section 422 of the Internal Revenue Code;

(2) The FICA and FUTA tax consequences of exercises of options to acquire employer stock under employer stock purchase plans that qualify for favorable income tax treatment under Section 423 of the Internal Revenue Code ("ESPPs"); and

(3) The income tax withholding and reporting obligations of employers relating to so-called "disqualifying disposition" of ISO and/or ESPP shares by employees (i.e., employee and former employee dispositions of the ISO or ESPP shares within the later of two years from the date of option grant or one year of the date of option exercise).

True to its word, the IRS issued guidance last week on these issues in the form of proposed regulations and two notices. Here are the details:

FICA and FUTA Withholding on Option Exercise. An employee or former employee who exercises an ISO or qualified ESPP option on or after January 1, 2003 will have FICA and FUTA "wages" in an amount equal to the excess of the fair market value of the shares received over their purchase price at the time of exercise. Accordingly, the employer will be required to withhold and remit applicable FICA and FUTA taxes on the spread realized on the exercise of ISO and ESPP options. Note, however, that the exercise of ISOs and ESPP options before 2003 will remain exempt from FICA and FUTA tax withholding, and that even after 2002 the exercise of ISO and ESPP options will continue to be exempt from income tax withholding. In light of these new rules, Executives holding appreciated ISOs may wish to consider exercising those options before 2003.

Permitted Withholding Conventions on Option Exercise. The IRS has proposed rules of administrative convenience that an employer can use to satisfy its FICA and FUTA withholding obligations with respect to ISO and ESPP exercises. The employer may elect to treat the "wages" arising from an ISO or ESPP option exercise as having been paid on a specific date, over one or more pay periods, quarterly, semi-annually or annually so long as the spread is treated as FICA wages not later than December 31 of the year of exercise and the employer uses the same withholding convention for all employees under the plan in question. Because of the ceiling on the amount of annual wages subject to full FICA taxation, treating the option-related "wages" as having been paid at year-end will normally minimize the amount of FICA taxes due. The IRS will also allow pre-funding of the FICA taxes, employer loans or advances to cover the FICA taxes, and acceleration of the date of FICA wage recognition if the employee terminates employment before the FICA taxes would otherwise be withheld.

Reporting But No Withholding on Disqualifying Dispositions. Consistent with current law and practice, the employer need not withhold income or employment taxes on a disqualifying disposition of shares acquired through ISO or ESPP option exercise. Beginning on a date to be announced in future IRS guidance (probably no earlier than mid 2002), however, the employer must make "reasonable efforts" to report all "disqualifying disposition" of ISO and ESPP shares by employees and former employees on an IRS Form W-2. Generally, option holders should be required as a condition to option grant or exercise to report disqualifying dispositions back to the employer. The employer can take a deduction for the amount of ordinary income recognized by an employee on a disqualifying disposition but needs to list that ordinary income amount on the employee's Form W-2.

Non-statutory Stock Options. None of the new IRS guidance described above relates to or modifies the existing tax rules applicable to non-statutory stock options or non-qualified stock purchase plans that fall outside Internal Revenue Code Sections 422 and 423.