IRS issues new rules on stock options.

• Author: Lerman, Jerry L.

Recently issued proposed regulations will change the way employers treat the exercise and disposition of stock acquired through an incentive stock option (ISO) plan.

NQSOs

Employer deduction. Sec. 83(h) allows employers to deduct as compensation amounts included in employees' income. If the options are not readily tradeable, the income would occur when the employee exercises the options. Under Regs. Sec. 1.83-6(a), income from nonqualified stock options (NQSOs) is deemed included in an employee's income as long as the employer timely issues either a Form W-2 or 1099. If the employer fails to do this, the deduction would be allowed only if the employee actually included the income on his return.

Employer withholding. Compensation income from the exercise of NQSOs is considered wages for employment tax purposes. Employers must withhold income taxes (at the flat rate on supplemental wage payments), and the income is subject to FICA and FUTA taxes. If an employer fails to withhold income taxes, tax payments made by the employee could be used to offset this withholding obligation, but the employer may be subject to failure-to-withhold penalties.

Because income occurs at the time of exercise of NQSOs, employers usually are in a position to meet the required withholding obligations. For example, in Letter Ruling 9025078, an employer was allowed to reduce the number of shares delivered to the employee on the exercise by the amount of withholding needed. The employer then remitted these funds to the IRS.

Another alternative is to include a provision in the stock option agreement under which the employer will not issue stock to the employee pursuant to the exercise of the NQSOs until the employee has provided the necessary cash to the employer to make the withholding payments.

ISOs

Employer deduction. Because employees do not have income at the time of the exercise of an ISO, there is no compensation deduction at that time. If, however, there is a disqualifying disposition of the stock acquired, the disposition would create compensation income for the service provider for the difference between the strike price and the stock's fair market value (FMV) at the time of exercise. A disqualifying disposition is a disposition of the stock within either two years from the date of the option grant or one year from the date of option exercise.

If a service provider enters into a disqualifying disposition, the employer can deduct the amount in the year it is...