Fringe benefit developments: stock options and qualified transportation fringes.

• Author: Dyson, Marianna G.

The Internal Revenue Service has been busy in recent weeks issuing guidance on several fringe benefit projects that were included in its 2000 Priority Guidance Plan. Included in the latest releases are Notice 2001-14, addressing the employment taxation of Incentive Stock Options (ISOs) and Employee Stock Purchase Plan (ESPP) options; Announcement 2001-7, postponing the earlier announcement requiring the segregated reporting of non-qualified stock option income on Forms W-2; and final regulations pertaining to qualified transportation fringe benefits. This article reviews these important developments.

Withholding on ISO and ESPP Option Income

After setting up dozens of proposed employment tax assessments and spending almost two years in the U.S. Court of Federal Claims defending a challenge to one such assessment in Micron Technology, Inc. v. United States, the Internal Revenue Service in mid-January issued Notice 2001-14,(1) which provides employment tax relief to employers with ISO plans and ESPPs. This Notice should allow taxpayers under audit and in Appeals on the issue of the proper employment taxation of ISOs and ESPPs to close out those cases on the basis of a full concession by the IRS. Those taxpayers who have been withholding employment taxes on ISOs and ESPP options should be entitled to refunds of the taxes paid for any open years.

ISOs and options granted under ESPPs do not generate option income to the employee when granted or exercised. Instead, at disposition of the stock received on exercise, compensation income may potentially be triggered. In Rev. Rul. 71-52,(2) the IRS concluded that neither the exercise of the statutory predecessors to ISOs and ESPP options, nor the disposition of the stock received on exercise of such options, resulted in wages subject to federal income tax withholding, FICA taxes, or FUTA taxes. The IRS in its private letter rulings applied the conclusions of Rev. Rul. 71-52 to ESPPs. And, consequently, taxpayers relied on Rev. Rul. 71-52 in concluding that employment taxes were not required to be withheld or paid in connection with the exercise of ISOs and ESPP options, or the disposition of the stock received on exercise of such options.

In Notice 87-49,(3) the IRS announced that it was reconsidering Rev. Rul. 71-52, but averred that it would apply Rev. Rul 71-52 to ISOs until further notice. Notice 87-49 was issued to address an issue in the proposed ISO regulations and had nothing to do with ESPPs. Nonetheless, the IRS subsequently reasoned that ESPPs might be treated differently from ISOs. The first the public heard of this distinction was in Private Letter Ruling 9243026 (June 24, 1992), in which the IRS concluded that FICA and FUTA taxes applied at the time of the ESPP option exercise to the difference between the fair market value of the stock and the exercise price and, further, that federal income tax withholding applied to the income on disqualifying disposition.

After PLR 9243026, the IRS focused in its employment tax audits on the employment tax treatment of ESPPs. Dozens of taxpayers received proposed assessments during such audits. The proposed assessments impose FICA taxes on the exercise of ESPP options and federal income tax withholding on disqualifying disposition of ESPP stock. Beginning in 1997, the IRS also audited ISO plans using the Tax Court's opinion in Sun Microsystems v. Commissioner(4) as ammunition. Sun Microsystems held that disqualifying disposition income qualified as wages for purposes of the research credit. One taxpayer, Micron Technology, Inc., challenged the IRS's position in the U.S. Court of Federal Claims. The other cases generally have been held in suspension at the audit or Appeals level pending the outcome of the Micron litigation.

Notice 2001-14 announces the end of this controversy -- at least for the back years and for the future through January 1, 2003. Specifically, with respect to ISOs and ESPP options exercised on or after publication of the notice and before January 1, 2003, the IRS will not assess FICA or FUTA taxes on exercise or require income tax withholding at disqualifying disposition. For exercises occurring before publication of Notice 2001-14, the employer may choose to apply this relief. Thus, Notice 2001-14 should permit taxpayers to resolve all ongoing audit and administrative appeals activity on this issue on the basis of a full concession by the government.

In addition, the IRS will honor otherwise allowable claims for refund of any FICA or FUTA taxes paid. Employers who have been withholding and paying FICA and FUTA taxes in connection with ISOs and ESPPs should file refund claims covering both the employee and employer shares of FICA taxes for all open years. The statute of limitations for claims with respect to FICA taxes and federal income tax withholding for 1997 expires April 15, 2001, unless it...