Statutory stock options are an important corporate tool used to compensate employees in a manner that traditional cash compensation cannot achieve by aligning employees' interests with those of their employers. Employee stock ownership has helped contribute to the United States' robust economy and the growth of the technology sectors. Although an overwhelming number of technology companies offer some type of statutory stock options (employee stock purchase plans [ESPPs] or incentive stock options [ISOs]), such options are also common in many other industries.
An integral aspect of statutory stock options that has contributed to their popularity is the favorable income and payroll tax treatment (FICA, FUTA and federal income tax withholding) enjoyed by such options. Now, thanks to a three-prong attack by the IRS, the Treasury Department and the Department of Justice, the payroll tax exclusion enjoyed by millions of employees with ownership stakes in their employers is being directly challenged. The purpose of this On the Subject… is to alert you to this challenge so you may respond appropriately to what is the most serious threat to date to the payroll tax exclusion, which has been universally applied to statutory stock options during the past three decades.
Employee stock purchase plans or ESPPs receive favorable income tax treatment under the Internal Revenue Code by allowing employees to purchase employer stock at a discount of up to 15 percent with no current income inclusion. If employees satisfy a minimum statutory holding period, they receive favorable capital gains treatment when the stock is sold. In light of prior IRS and Treasury guidance, corporate employers have universally adopted a reasoned position that ESPPs are exempt from payroll taxes (even on "disqualifying dispositions" where employees fail to hold the stock for the minimum time period). Additionally, the Financial Accounting Standards Board (FASB) has recently upheld the position that ESPPs do not result in an accounting compensation expense to the employer. These combined tax and financial accounting incentives have achieved the desired Congressional goal of broad-based employee ownership.
Not only do technical legal arguments support this favorable and longstanding payroll tax treatment, but practical considerations also prevent payroll tax withholding in most situations. For example, when an employee makes a stock purchase through an ESPP, he or she receives stock and the employer has made no cash payment from which it can withhold payroll taxes. Similarly, when an employee disposes of the underlying stock, the employer typically is not in a situation to know when and how much stock the employee has sold and for what price–even assuming the individual has remained an employee.
The principal authority for the position that ESPPS are exempt from payroll taxes is an almost 30-year-old ruling (IRS Revenue Ruling 71-52) in which the IRS held that qualified stock options (under former Code Section 422) do not create wages when they are exercised nor when the stock is disposed of in a disqualifying disposition. In IRS Notice 87-49, the IRS formally extended that favorable payroll tax treatment to incentive stock options or ISOs–a type of statutory stock option plan similar in many respects to ESPPs. Employers and tax advisors have naturally assumed that the ISO position would also extend to ESPPs, especially since they cover all of an employer's employees (including millions of rank-and-file employees) and ISOs primarily cover executives and senior managers. To do otherwise would impose new payroll taxes on the segment of workers least capable of handling the burden. The IRS did not aggressively challenge this historic assumption until the mid-90s.
Case Law Developments and IRS Audit Activity
In 1995, the United States Tax Court in Sun Microsystems Inc. v. Commissioner held in favor of the taxpayer that "disqualifying dispositions" of ISO stock generate "wages" as defined for income tax withholding purposes, thereby entitling the sponsoring employer to a research tax credit. Sun Microsystems treated the disqualifying dispositions as wages for purposes of the tax credit, but it had not treated that same amount as wages for payroll tax purposes due to its reliance on Rev. Rul. 71-52. The specific payroll tax treatment was not directly challenged by the IRS. Instead, the IRS challenged the tax credit on the basis that Rev. Rul. 71-52 held that disqualifying dispositions of shares purchased under ISOs (but not ESPPs) are excluded from wages for payroll tax purposes and, therefore, a tax credit based on wages paid for income tax withholding purposes should be denied. The IRS allowed the tax credit associated with the ESPPs due to its administrative position that disqualifying dispositions of ESPP stock constitute wages.
In granting Sun Microsystems its tax credits, the Tax Court found ISOs and ESPPs to be indistinguishable for purposes of determining the proper wage treatment. It refused to apply Rev. Rul. 71-52's rationale and the IRS' "ipse dixit" statement that disqualifying dispositions of ISO stock do not constitute wages under Rev. Rul. 71-52. However, the Tax Court did not invalidate the "totally unpersuasive" ruling nor prohibit the IRS from continuing to be bound by its historic position not to pursue withholding on disqualifying dispositions.
Conceding the Tax Court's legal analysis, the IRS announced in 1997 that it would follow the Sun Microsystems decision in future cases and audits. As a result, IRS auditors began to challenge the continued payroll tax exemption of statutory stock options, primarily ESPPs, under Rev. Rul. 71-52 and Notice 87-49. In particular, the IRS has been seeking payroll tax assessments from both employers and rank-and-file employees for income tax withholding on disqualifying dispositions and FICA taxation on exercises of ESPP options. The IRS asserts that employers and employees may no longer rely on its prior guidance because they should have known that the IRS' acquiescence to the Tax Court's Sun Microsystems decision implicitly revoked Rev. Rul. 71-52. The IRS National Office issued a "field service advice memorandum" to one of it’s agents in April 1999 confirming this audit position. In that guidance, IRS agents have been instructed that the difference between the option price and the fair market value (FMV) of ESPP stock on the exercise date constitutes taxable wages for FICA tax purposes.
In February 1999, Micron Technology (one of the IRS' apparent audit targets) filed a refund action in the United States Court of Federal Claims aggressively challenging the IRS' audit position (Micron Technology, Inc. v. United States, No. 99-61 T). Although a small case in terms of actual disputed dollars, this case has permanently propelled this issue to the national spotlight. Consequently, the IRS has no longer been able to support the "don't ask, don't tell" policy previously adopted by many IRS agents regarding the payroll tax treatment of statutory stock options.
Given the Court of Federal Claims' role as a court of national jurisdiction, far more is at stake for thousands of corporations and millions of employees than ever during the past 30 years regarding statutory stock options. Little has been accomplished in this case during the past 18 months. In fact, the government has indicated that it is being "stonewalled" and the judge has warned that he does not want to "referee squabbles" between the parties.
During this same time period, several industry associations have actively petitioned Congress, the IRS and the Treasury Department demanding that the IRS discontinue its audit activity pending a decision in Micron Technology. In particular, these efforts point out the inequity of attempting to reverse through audits (rather than official public pronouncements) the IRS' longstanding positions in Rev. Rul. 71-52 and Notice 87-49 that waive payroll taxes on various types of statutory stock option plans. These association lobbyists have asked the Treasury Department to issue formal guidance both affirming and extending the historic position. Absent a complete government concession, they have asked that employers be given flexibility regarding how to implement withholding and that any adverse guidance be given prospective effect.
The Treasury Department and the IRS responded by placing this issue on their official Treasury-IRS 2000 Priority Guidance Plan. The 2000 Guidance Plan contains items on which tax guidance will be issued during the 2000 calendar year.
Apparently underestimating the extensive delays in the Micron Technology litigation, the Treasury Department and the IRS have opted not to rely solely on a judicial resolution to this contentious issue. The guidance project under the 2000 Guidance Plan has apparently moved to center stage because the Treasury Department is now expected to release proposed tax regulations within the next several months (possibly before December 12th of this year). Preliminary indications are that these proposed regulations would formally subject statutory stock options to payroll taxes for the very first time. This change in strategy by the Treasury Department and the IRS has prematurely come to light due to a Department of Justice court filing.
On September 28, 2000, the Tax Division of the Department of Justice filed a Motion for Enlargement of Time in the Micron Technology litigation until December 12, 2000. The Department of Justice specifically indicated that its litigating position is under evaluation "in light of proposed guidance relating to employee stock purchase plans being prepared" jointly by the IRS and the Treasury Department. The Department of Justice stated that "such guidance could affect the two issues in this case, the correct application of the income tax withholding provisions and FICA tax provisions with respect to employee wages attributable to the exercise of stock options acquired through employee stock purchase plans described in Section 423 of the Internal Revenue Code or to the subsequent disposition of stock purchased under such options." Although the guidance could technically take the form of a revenue ruling, this language indicates that the guidance will in fact take the form of proposed regulations.
Anticipated Treasury Regulations
Although it is unclear exactly what the current draft of the proposed regulations provides, the contents are of a significant enough nature to cause the Department of Justice to reassess its litigation position. On a positive note, the Department of Justice apparently believes that the IRS and Treasury will at least backtrack on certain aspects of the audit and litigation positions. Similarly, industry representatives who have met with the Treasury Department on this issue believe a mutual understanding exists that any new FICA taxes on ESPPs would be more limited than the position being asserted in Micron Technology, i.e., FICA withholding would be at the time of the option exercise, and the taxable FICA wages would be the lesser of (1) the excess of the share's FMV over the option price when granted (in a rising market) or (2) the excess of the share's FMV over the option price at the end of the option period (in a declining market). Persuasive arguments were made that there should be no income tax withholding due to the administrative difficulties of such withholding.
The draft regulations almost certainly will not amount to a complete government concession on FICA withholding given the IRS' recent position on both ESPPs and ISOs as demonstrated by its prior "informal" guidance to its auditors; the audit and litigation positions in Micron Technology; and last year's Treasury Department discussions with industry leaders. Otherwise, we believe the Department of Justice would have conceded its case in Micron Technology rather than face embarrassment or the wrath of the federal judge hearing the case. Consequently, we anticipate that proposed payroll tax regulations will subject the option spread to FICA taxes on a prospective basis (it is uncertain how the spread will be calculated or whether there will be an exemption for ISOs), but not income tax withholding. Given the greater difficulties associated with income tax withholding on disqualifying dispositions, the government may finally abandon its assertion that there must be income tax withholding on statutory stock options.
The IRS National Office refused specific comment on the proposed regulations due to the ongoing Micron Technology litigation. A conversation with the Treasury Department confirmed our understanding that proposed regulations are being prepared, but not the specific content of the tax positions being taken by those proposed regulations.
Although the proposed regulations are a negative development from the perspective of the historic payroll tax treatment, they appear more favorable than the position being asserted by the IRS in audits and by the Department of Justice in its Micron Technology filings. From a technical legal perspective, the proposed regulations can perhaps be viewed as a reasoned middle ground. However, to the corporations sponsoring these stock options, this position will impose a significant administrative burden. The millions of rank-and-file employees affected by these regulations will have concerns about the direct financial impact of such proposed regulations. Numerous employers have stated that their employees would be less likely to retain their shares after the exercise of ESPP options because they will have to sell their stock to cover this new payroll tax liability.
Although various advisors have sounded the alarm in the past concerning the possibility of IRS challenges to the payroll tax treatment of ESPPs and ISOs, there has been no greater threat to the three-decade-old payroll tax exemption than that currently being raised by Micron Technology and the regulations that have been drafted in response to that contentious dispute. The prospect of proposed regulations raises significant questions that corporate employers must address including the retroactive or prospective nature of those positions, the potential new taxes imposed on both employers and employees, the possible erosion to broad employee stock ownership, and the increased administrative costs associated with tracking, withholding and reporting on option exercises and stock dispositions.
Although there has not yet been any significant legislative activity on this issue, Congress has shown interest in this topic. On October 12, 2000, the Subcommittee on Oversight of the House Committee on Ways and Means held a hearing on stock option plans. In his announcement of the hearing, the Chairman of the Subcommittee, Congressman Houghton (R-NY), provided a broad overview of stock option plans, including his understanding that "no income or employment tax withholding is currently required for either the discount or for disqualifying dispositions." Furthermore, Chairman Houghton has previously urged the IRS to desist from its current enforcement efforts and return to its prior historical position.
The Subcommittee heard testimony on October 12th that raised concerns that "the IRS and Treasury are poised to issue guidance that could support the imposition of employment tax and withholding obligations on certain ESPP and perhaps even ISO transactions." Congress was urged to enact legislation that would overturn any such proposed guidance. The principal reasons cited for a legislative remedy to this payroll tax dispute are the substantial administrative burdens on employers and the likelihood that many rank-and-file employees would be less likely to retain their shares due to the need to sell the stock to cover both the FICA tax and income tax withholding liability. Together, these two reasons were cited as possible deterrents to the ongoing sponsorship of ESPPs. Although there are currently no House bills that address this issue, initial efforts are underway in the Senate (Sen. Craig, R-ID) to introduce legislation in 2001 that would exempt ESPPs and ISOs from payroll taxes.
McDermott, Will & Emery's Tax and Benefits Departments have been tracking these issues for years. With the input of two former IRS attorneys who were closely involved with this stock option issue while at the IRS National Office, we have consistently advised clients and friends of the firm regarding both the technical and practical considerations regarding statutory stock options, including providing information on potential government challenges. Our advice and analysis have been consistent with the historic treatment of this issue, i.e., most employers have historically treated statutory stock option plans as exempt from payroll taxes both when the option is granted and exercised and when the employer stock is sold.
Given the very preliminary stages of this issue in Congress and the imminent threat to the ongoing payroll exclusion from the IRS, the Treasury Department and the Department of Justice, corporate employers should strongly consider steps to lobby against the proposed guidance either singularly or as part of a broader coalition. The primary goal of such lobbying efforts should be to adopt legislation confirming the historic payroll tax exclusion. At a minimum, a concentrated effort should be made to ensure that any proposed guidance is at least only prospective in nature.