IRS Proposes to Tax Incentive Stock Options and Employee Stock Plans

11/15/2001

The Internal Revenue Service has issued proposed regulations and other guidance that would impose FICA and FUTA taxes on all amounts received from incentive stock options and employee stock purchase plans.  These rules have only been proposed and will not become applicable unless they become final.  Under the proposed guidance:

  • The excess of the value of the stock acquired over the amount paid for the stock (the “Spread”) will be subject to FICA and FUTA at the time of exercise or purchase.

Example.  An employee participates in Corporation A’s employee stock purchase plan.  The plan has an offering period running from January 1, 2003 to December 31, 2003.  Under the plan, the employee may acquire fifty shares of Corporation A common stock at a purchase price equal to 85% of the value of the stock as determined on January 1, 2003.  The value of the stock on January 1, 2003 equals $100.  The employee purchases the stock under the plan on December 31, 2003, when the stock is worth $120 per share, paying only $85 per share.  Thus, the employee receives a Spread equal to $35 per share.  In this example, the employee’s purchase of the stock results in a payment of $1,750 ($35 times 50 shares) that is subject to FICA and FUTA for the 2003 tax year. 

  • The Spread will not be subject to federal income tax withholding provided the employee is not taxed on the Spread due to the qualified status of the incentive stock option or the employee stock purchase plan.
     
  • Employers will not have any income tax withholding obligation upon an employee’s disqualifying disposition of stock received pursuant to the exercise of an incentive stock option or under an employee stock purchase plan.
     
  • Employers must make reasonable efforts to ascertain whether a disqualifying disposition has occurred, so that any resulting income received must be reported to an employee or former employee engaging in the disqualifying disposition.  In any case in which the employer takes a tax deduction for the disqualifying disposition, the employer must report the income on Form W-2 or Form 1099, as applicable.  The employer will not be required to provide a Form W-2 or Form 1099 if the employer has made reasonable efforts and cannot determine whether a disqualifying disposition has occurred.

RULES OF ADMINISTRATIVE CONVENIENCE

  • For administrative convenience, employers may deem the FICA and FUTA wages resulting from the purchase of the stock to be paid on a pay period, quarterly, semi-annual, annual or other basis, provided the deemed payments do not begin prior to the time the stock is purchased or after December 31 of the year in which the stock is purchased.  Employees also can agree to pre-pay their FICA and FUTA tax obligations to the employer through payroll deductions or otherwise

EFFECTIVE DATES

  • If these rules are implemented as proposed, they will be effective for stock purchased on or after January 1, 2003.  It is recommended that, when considering option grants now, companies take into account the potential costs and cash flow requirements that may arise if these regulations are finalized.
     
  • The guidance on income tax withholding and rules of administrative convenience will be effective after subsequent guidance is provided with final rules.

If you have any questions about these proposed rules or how to design your plan to avoid or reduce employment taxes, please contact one of the authors listed at the top of the page.

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