On November 13, 2001, the IRS issued proposed regulations to impose federal payroll taxes on gains realized from exercising incentive stock options (ISOs) and employee stock purchase plans (ESPPs). Federal payroll taxes under Federal Insurance Contributions Act (FICA) may be assessed at combined employer-employee rates ranging from 2.9 percent to 15.3 percent of the option gain on exercise depending upon the employee's compensation level. This change is proposed to be effective for options exercised after December 31, 2002.
The IRS also issued two notices proposing additional rules regarding withholding practices. Notice 2001-72 provides an income tax withholding exemption for gains triggered by selling stock acquired under an ISO or ESPP. This exemption is the only positive news from the IRS guidance. Notice 2001-73 proposes several administrative rules for employers to use when withholding payroll taxes.
The proposed rules, if finalized, will significantly increase the cost to employers of providing equity incentives under ISOs and ESPPs. In addition, complicated payroll tax withholding procedures will need to be established. Comments may be submitted to the IRS regarding these proposed rules by February 14, 2002.
As we suggested in our prior On the Subject releases, dated January 2001 and October 2000, legislative action may be required to preserve the longstanding payroll tax exemptions enjoyed by ISOs and ESPPs.
Click here if you would like to review our detailed analysis of this guidance and actions that employers may take in the interim.