IRS proposes employment tax on the exercise of statutory stock options.

• Author: Packard, Pamela

On Nov. 14, 2001, the Service issued proposed regulations that would impose employment taxes on the exercise of statutory stock options (i.e., incentive stock options (ISOs) under Sec. 422 and options granted pursuant to an employee stock purchase plan (ESPP) under Sec. 423). The proposed regulations will apply to the exercise of statutory stock options as of Jan. 1, 2003.

Background

In Rev. Rul. 71-52, the IRS ruled that qualified-stock-option exercises were not wages for payroll purposes or subject to employment taxes. Also, when an employee sold the stock, employers did not have to withhold Federal income taxes. When ISOs replaced qualified stock options in the early 1980s, employers continued to exclude statutory-stock-option exercises from income tax withholding and FICA and FUTA taxes.

In Notice 87-49, the Service indicated that it was reconsidering the holdings of Rev. Rul. 71-52, but until it changed that ruling, it was extending payroll and withholding exemptions to ISOs and disqualifying dispositions of statutory option stocks. Because of the similarities between these options and ESPPs, employers assumed ESPPs received similar favorable tax treatment.

Guidance in 2001

In February 2001, the IRS issued Notice 2001-14, indicating that Rev. Rul. 71-52 was obsolete and did not apply to statutory option exercises, and that Notice 87-49 was no longer applicable. The Service indicated it would issue guidance to clarify the application of income, FICA and FUTA tax withholding on ISOs and ESPPs. In the interim, employers are not required to withhold taxes for options exercised before 2003.

In November 2001, the IRS issued updated guidance as proposed regulations under Secs. 3121, 3306 and 6041. In addition, it issued Notice 2001-72, requiring taxpayers to report obligations on "disqualifying dispositions" of stock received from the exercise of statutory stock options, and Notice 2001-73, referring to the imposition of FICA and FUTA taxes.

The proposed regulations subject both ISOs and options granted under an ESPP to employment taxes. An employer incurs FICA and FUTA tax obligations when an individual exercises the options (which can prove to be an administrative nightmare). The amount subject to taxation is equal to the "spread" at exercise, the difference between the stock's fair market value at exercise and the option's exercise price. The Service does not require the employer to withhold income taxes when the individual exercises the...