Application of employment taxes to statutory stock options.

• Author: Moore, Philip E.

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...