IRS Issues Incentive Stock Options Guidelines


The following article is provided courtesy of CCH, Inc.


The IRS has issued proposed regulations relating to incentive stock options (ISOs) described in Code Sec. 422(b) and options granted under an employee stock purchase plan (ESPP options) described in Code Sec. 423(b). The proposals, which would affect employers granting such options and employees exercising the options, provide guidance concerning the application of the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA) and Collection of Income Tax at Source to the options. The IRS also released two related notices that set forth proposed rules regarding (1) an employer's income tax withholding and reporting obligations upon the sale or disposition of stock acquired pursuant to the exercise of a statutory stock option and (2) application of FICA and FUTA to statutory stock options.

Proposed Regulations

The proposed regulations would clarify current law regarding FICA and FUTA taxes and income tax withholding on the transfer of stock pursuant to the exercise of statutory stock options. At the time an option is exercised, the individual who was granted the statutory stock option would receive wages for FICA and FUTA purposes. Also, the amount of wages received would equal the excess of the fair market value of the stock acquired pursuant to the exercise of the statutory stock option over the amount paid for the stock.

The proposals follow the congressional directive that no exception from FICA taxes should be created without a specific exclusion and the statutory requirement that no exception from FICA and FUTA taxes should be inferred from the fact that income tax withholding does not apply. Further, the regulations would provide that income tax withholding would not be required when an individual exercises a statutory stock option because no income is recognized at the time of the exercise in accordance with Code Sec. 421(a)(1).

The IRS would be authorized to adopt rules of administrative convenience to assist employers and employees in meeting the employment tax obligations. Specifically, the proposals permit the IRS to adopt rules allowing employers to deem the payment of wages resulting from the exercise of a statutory stock option as occurring at a specific date or dates, including over a period of dates, as well as any other appropriate rules of administrative convenience.

For purposes of the rules governing ISOs and ESPP options, if the terms of any option to purchase stock are modified, extended or renewed, those modifications, extensions or renewals would be considered as the grant of a new option. Code Sec. 424(h)(3) generally defines the term "modification" as any change in the terms of the option that gives the employee additional benefits. The proposals would clarify that the adoption of any of the rules of administrative convenience that might be prescribed by the IRS and the application of those rules to outstanding ISOs or ESPP options would not constitute a "modification" under Code Sec. 424(h).

The rules are proposed to apply only upon publication of final regulations, and cannot be relied upon prior to publication. Upon finalization, the regulations would be effective only for the exercise of a statutory stock option that occurs on or after January 1, 2003. If the regulations are finalized as proposed, neither FICA nor FUTA tax will apply to the exercise of a statutory stock option prior to January 1, 2003. Consistent with that proposed provision, the IRS will not assert FICA or FUTA tax that is based upon the exercise of a statutory stock option that takes place prior to January 1, 2003. Further, employers will be able to elect to apply the final regulations to the exercise of statutory stock options that occur prior to January 1, 2003.

Hearing on Proposed Regulations

A public hearing on the proposals will begin at 10:00 a.m. on March 7, 2002, in the Auditorium, Internal Revenue Building, 1111 Constitution Ave., NW., Washington, D.C. Interested parties have until February 14, 2002, to submit comments and outlines of topics to be discussed at the hearing to the IRS, P.O. Box 7604, Ben Franklin Station, Room 5226, Attn: CC:ITA:RU (REG-142686- 01), Washington, D.C. 20044. Comments may also be submitted electronically by selecting the "Tax Regs" option on the IRS's homepage at www.irs.gov.

Notice 2001-72

In conjunction with the issuance of the regulations, the IRS has released proposed rules dealing with an employer's income tax withholding and reporting obligations upon the sale or disposition of stock acquired by individuals pursuant to the exercise of ISOs or ESPP options. As a response to comments on Notice 2001-14, I.R.B. 2001-6, 416, which addressed the application of employment taxes to statutory stock options, the IRS has proposed that an employer would have no income tax withholding obligation when an employee sells or disposes of stock acquired pursuant to the exercise of an ISO or ESPP option. For purposes of the notice, the term "employee" also refers to former employees.

Under certain circumstances, a payment from an employer to an employee would have to be reported on Form W-2 even if the payment is not subject to income tax withholding. Reporting would be required if the total amount of the payment and other payments of remuneration, if any, made to the employee that are subject to reporting on Form W-2 equal at least $600 in a calendar year. The employer would have to make reasonable efforts to ascertain whether it has to provide a Form W-2 to an employee who has received remuneration that is not subject to income tax withholding upon a sale or disposition of stock acquired pursuant to the exercise of an ISO or ESPP option.

The employer would be deemed not to have made reasonable efforts in circumstances where it claims a Code Sec. 83 deduction for the payment of remuneration to an employee but fails to provide a Form W-2 reporting that remuneration to the employee, if the total amount of the payment along with other remuneration that is reportable on Form W-2 aggregate at least $600 in that calendar year. An employer that has made reasonable efforts but that cannot determine whether remuneration has been paid would not have to provide a Form W-2.

Notice 2001-73

Pursuant to authority to be granted to the IRS under the proposed regulations, the second notice sets forth proposed rules of administrative convenience relating to the application of FICA and FUTA taxes to ISOs and ESPP options. An employer would be permitted to treat FICA and FUTA wages resulting from the exercise of a statutory stock option as paid on a pay period, quarterly, semiannual, annual or other basis. Also, an employer could opt to treat FICA and FUTA wages resulting from the exercise of a statutory stock option as paid over more than one period.

The deemed payments could not commence before the exercise occurred, and all payments would generally have to be treated as paid on or before December 31 of the year of the exercise. The employer could change the method used at any time without making a former election or providing notification to the IRS.

The employer would be allowed to choose to treat the wages resulting from the exercise of a statutory stock option occurring in December, or any shorter period ending on December 31, as paid in the first quarter of the following calendar year. However, an employer that treats any or all wages resulting from the exercise of a statutory stock option during the first 11 months of the calendar year as paid, in whole or in part, during December would not be permitted to treat those wages as paid in the first quarter of the following calendar year. Employers using this special accounting rule would not have to make a formal election or provide notification to the IRS.

Additional guidelines deal with arrangements in which an employer and an employee contractually arrange for the employee to prefund the amount of the employee portion of FICA tax that will arise upon the exercise of a statutory stock option; arrangements made by an employer to advance the funds necessary to pay the employee portion of FICA tax and obtain reimbursement of those funds from the employee; and a consistency rule under which the employer would have to apply the chosen rule consistently to all employees eligible to participate under the relevant ISO or ESPP option.

Comments Sought on Notices

The proposed rules set forth in the two notices will not take effect until subsequent notices containing final rules are released. Interested parties have until February 14, 2002, to submit comments on the rules, referencing Notice 2001-72, to the Associate Chief Counsel (Tax Exempt and Government Entities), CC:TEGE, Attn: Statutory Stock Options and Income Tax Withholding, Room 5214, IRS, 1111 Constitution Ave., NW., Washington, D.C. 20224. Comments referencing Notice 2001-73 should be submitted to the Associate Chief Counsel (Tax Exempt and Government Entities), CC:TEGE, Attn: Employment Taxes, Statutory Stock Options and Proposed Rules of Administrative Convenience, Room 5214, IRS, 1111 Constitution Ave., NW., Washington, D.C. 20224.

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