Special annual tax reporting requirements apply to employers who grant incentive stock options (ISOs) or maintain employee stock purchase plans (ESPPs). The IRS has recently clarified these requirements in response to requests for guidance by its agents.
Section 6039 of the Internal Revenue Code requires employers who transfer stock upon the exercise of an ISO to provide the optionee, whether or not then employed, an information statement no later than January 31st of the following calendar year. A similar requirement to provide an information statement applies each time that an employer (or its transfer agent) records the first transfer of legal title to ESPP stock to a participant.
These requirements are intended to assist employees in reporting taxable income from ISOs and ESPPs. Sample ISO and ESPP information statements are available upon request. An employer may provide information statements by hand delivery or mail to the employee’s last known address.
Failure to provide information statements will result in a $50 penalty per statement (up to a maximum of $100,000 per calendar year) unless abated for reasonable cause. "Failure" is defined as either a failure to furnish a timely statement, or a failure to include all of the information required or inclusion of incorrect information. Increased penalties may apply if an employer intentionally disregards the reporting requirement.
Reporting for Disqualifying Dispositions
Federal tax rules also provide for employers to report ordinary income resulting from a disqualifying disposition of either ISO or ESPP shares. A "disqualifying disposition" is a disposition of ISO or ESPP shares within two years of the date of grant (i.e., for ESPP shares, the first day of the offering period in which the shares were purchased) or within one year of the date on which the shares were purchased.
Amounts reported as ordinary income are deductible by an employer for federal income tax purposes. The ordinary income resulting from a disqualifying disposition is equal to the lesser of the "spread" (i.e., the difference between the stock’s fair market value and the exercise price) on the exercise date or the actual gain recognized on the disposition of the shares.
Failure to report jeopardizes an employer’s ability to deduct ordinary income resulting from a disqualifying disposition. Reporting penalties may apply as well.
The IRS maintains that an employer should report income resulting from a disqualifying disposition:
- On a Form W-2 as "other compensation."
- However, some employers report income from a disqualifying disposition on a Form 1099-MISC if the participant (or former participant) was not an employee in the calendar year of the disposition, the participant’s ordinary income from the disposition is $600 or more and the employer has the information necessary to determine the amount of income.
Tax Withholding for Disqualifying Dispositions
Withholding for income taxes and employment taxes (i.e., FICA and FUTA) is not required for gains resulting from either the purchase or disqualifying disposition of ISO and ESPP shares for 2001 and 2002 under an IRS moratorium. For more information regarding the IRS moratorium and federal employment taxes regarding ISOs and ESPPs, please see our November 2001 On The Subject… entitled "IRS Imposes Payroll Taxes on Incentive Stock Option and Employee Stock Purchase Plans."