April 23, 2002

CC:ITA:RU (REG-142686-01)

Room 5226
Internal Revenue Service
POB 7604
Ben Franklin Station
Washington, D.C. 20044

Re: Comments on Notice of Proposed Rulemaking
and on Notices 2001-72 and 2001-73

Dear Sir or Madam:

I am writing on behalf of AeA (the American Electronics Association), and its member companies, in response to the Internal Revenue Service’s (the "IRS’") request for comments on the proposed regulations in Notice of Proposed Rulemaking REG-142686-01, and on Notices 2001-72 and 2001-73 (together, the "proposed regulations").

AeA is the nation’s largest high-tech trade association. It has more than 3,500 member companies that span the high-technology spectrum, from software, semiconductors, and computers to Internet technology, advanced electronics, and telecommunications systems and services. As discussed below, AeA is of the view that the guidance outlined in the proposed regulations is both unlawful and administratively impractical for the employer. AeA urges the IRS and the Treasury Department ("Treasury") to reconsider the administrative guidance outlined in the proposed regulations and to issue, instead, guidance confirming that neither the purchase of shares pursuant to an Employee Stock Purchase Plan ("ESPP") nor the exercise of Incentive Stock Options ("ISOs") requires the imposition of FICA or FUTA taxes.

AeA commends the IRS and Treasury for acknowledging and incorporating two very important premises in the proposed regulations, both of which need to be incorporated into the final rulemaking as well:

1. Stating that Federal income tax withholding is not required at exercise of ISOs and ESPP options and
2. Acknowledging that "An employer would have no income tax withholding obligation when an employee sells or disposes of stock acquired by the employee pursuant to the exercise of an ISO under section 422 or an option granted under an ESPP under section 423."

This letter focuses on the reasons that the guidance outlined in the proposed regulations is contrary to the Internal Revenue Code, the legislative history of the statutory option and FICA tax statutes, and case authority. In addition, this letter outlines some of the administrative difficulties of the approach outlined in the proposed regulations.

1. FICA and FUTA Taxation of ESPPs and ISO Plans.

The proposed regulations establish administrative guidance [to be effective no earlier than January 1, 2003] which reflects the view that the statute defines ‘wages’ for FICA and FUTA tax purposes broadly, without any statutory exclusion for exercises of statutory options. In the context of the background information provided in the proposed regulations, the clear implication is that the administrative guidance requires imposition of FICA and FUTA¹ taxes at the time ESPP options and ISOs are exercised. As discussed below, any such requirement that FICA taxes be imposed at exercise would be unlawful.²

The language and structure of the FICA statute do not permit the imposition of FICA taxes at the time an ESPP option or ISO is exercised. Sections 3101(a) and (b) of the Internal Revenue Code (the "Code") provide that "there is hereby imposed on the income of every individual a tax equal to [a specified] percentage of wages." (Emphasis supplied.) Section 421(a)(1) clearly states that, in the case of ESPP options and ISOs, "no income shall result at the time of the transfer of such share to the individual upon his exercise of the option with respect to such share." Because there is no income under section 421(a) at ESPP option and ISO exercise, there is no income for purposes of section 3101(a) and (b). Consequently, FICA taxes cannot be imposed at that time.

Each of the four United States Circuit Courts of Appeal that have been faced with the issue has rejected the IRS’ arguments that amounts that are excluded from income can nonetheless be subjected to FICA taxes. In Anderson v. United States, 929 F.2d 648 (Fed. Cir. 1991), acqu. in result only recommended in AOD 1991-017, 1991 AOD Lexis 37, the Federal Circuit considered whether certain housing allowances ("ODAA payments"), which were concededly excluded from income by Code section 912(1)(c), were wages for FICA purposes. The Court held that "Given the scheme of the income and FICA tax statutes . . . it follows that ODAA payments cannot be treated as ‘wages’ under FICA if they are not first made ‘income.’" 929 F.2d at 654. The IRS’s argument that the ODAA payments were FICA wages even though excluded from income was rejected because ‘the language and structure of the FICA tax statute . . . conditions imposition of FICA taxes on income." 929 F2d at 654.³ The Federal Circuit’s conclusion that amounts excludable from income cannot be wages was followed by the Ninth Circuit in Redfield v. Insurance Co. of North America, 940 F.2d 542 (9^th Cir. 1991), by the Fifth Circuit in Dotson v. United States, 87 F.3d 682 (5^th Cir. 1996), and by the Sixth Circuit in Gerbec v. United States, 164 F.3d 1015 (6^th Cir. 1996). See also Central Illinois Public Service Company v. United States, 435 U.S. 21, 31 (1978) and cases cited therein for the proposition that wages are a subset of income. In light of these authorities, the IRS and Treasury cannot, in good conscience, propose regulations requiring the imposition of FICA taxes at exercise, when there is no income.

The IRS and Treasury appear to be taking the position in administrative guidance that, while there may not be income at exercise, FICA taxation at exercise is nonetheless justified because there will be income at disposition of the stock. However, it is simply not true that the spread on option exercise will inevitably be income to the employee on disposition of the stock. In the case of a disqualifying disposition of ISO stock, the amount includible in income is limited to the gain on the disposition. Code section 422(c)(2). Where there is no gain on the disposition because the amount realized is equal to or less than the option price, there is no income at disqualifying disposition. In the case of a qualifying disposition of ESPP stock, the income also can be limited. Code section 423(c). Consequently, any imposition of FICA tax at exercise would be a tax on an estimate of future income that may not be realized. Taxation of such an estimate cannot possibly be good tax policy. It seems likely that the reason the IRS and Treasury are considering imposing FICA tax on an estimated amount of income at exercise is that this approach raises the most revenue. Obviously, if the IRS guidance did not impose FICA taxation until disposition of the stock (and there would be completely different legal problems with any such approach), and the income at that time was less than the spread at exercise because of a decline in the market price of the stock, less FICA taxes would be imposed. However, the ability to raise more revenue does not justify imposing FICA taxation on the spread at option exercise because that amount is not income at exercise and, in fact, may never be income in the future.⁴

Confirmation of the fact that there is no compensation income that can be subjected to FICA tax at option exercise is found in the fact that the employer is not entitled to a compensation deduction at exercise, but is only entitled to a compensation deduction at disqualifying disposition. Code section 83(e)(1) and (h); Reg. § 1.83-6; Reg. § 1.421-8(b)(1). Further confirmation that there is no compensation income that can be taxed at exercise can be found in the IRS’ position with respect to the effect the exercise of statutory options has on earnings and profits. The IRS’ litigation position in this area has been that statutory stock options are not compensatory at exercise and, consequently, are not expenses that reduce corporate earnings and profits. Divine v. Commissioner, 500 F.2d 1041 (2^nd Cir. 1974); Luckman v. Commissioner, 418 F.2d 381 (7^th Cir. 1969). Consistent with this litigation position, the IRS has published guidance, Rev. Rul. 2001-1, 2001-9 I.R.B. 726, stating that earnings and profits are reduced (with implications for the adjusted current earnings adjustment for alternative minimum tax purposes) for exercises of nonstatutory options, but not for exercises of statutory options. The implication is that the IRS continues, for earnings and profits and alternative minimum tax purposes, to view statutory options, i.e., ESPP options and ISOs, as not compensatory at exercise. Otherwise, Rev. Rul. 2001-1 would have reached the same result with respect to ESPP options and ISOs as it had for nonstatutory options. Having just recently issued guidance in January 2001 indicating that statutory options are not compensatory at exercise for earnings and profits purposes, the IRS should now be consistent and should promulgate administrative guidance stating that such options are not compensatory at exercise for FICA tax purposes either. Such guidance would not only be consistent with the IRS’ position with respect to earnings and profits and the adjusted current earnings provision of the alternative minimum tax, but it would be consistent with the Anderson line of cases.

The proposed regulations do not mention the Anderson line of cases⁵, but states that the legislative history of the Social Security Amendments Act of 1983 "makes clear . . . that an item of income can be wages for FICA tax purposes even if it is not wages for income tax withholding purposes." It is irrefutable that an item of income can be treated by regulation as FICA wages, but not as Federal income tax withholding wages. This is exactly what the Social Security Amendments Act of 1983 allowed. However, that is not what the IRS is proposing to do in the administrative guidance. What the IRS is proposing to do is something that is not sanctioned by the Social Security Amendments Act of 1983 and that is directly contrary to the Anderson line of cases. That is, the IRS is proposing to treat an item that is not income as wages for FICA tax purposes. This proposal is not only inconsistent with case law, but it is not within what the Social Security Amendments Act of 1983 permits.

Instead, the Social Security Amendments Act of 1983 had much more limited an impact than the proposed regulations would indicate. The Act overruled the holding in Rowan Companies, Inc. v. United States, 452 U.S. 247 (1981). The Rowan case involved the excludability for FICA tax purposes of meals provided to employees on offshore drilling rigs. The Federal income tax withholding regulations specifically excluded such meals from wages for purposes of Federal income tax withholding, but the FICA regulations contained no such exclusion for FICA wages. The Supreme Court in Rowan held the FICA regulations invalid because they failed to implement the congressional mandate in a consistent and reasonable manner in that they interpreted the substantially similar term "wages" differently for FICA purposes than they did for Federal income tax withholding purposes. The Social Security Amendments Act of 1983 overruled Rowan by adding the flush language at the end of Code section 3121(a). This language simply says that "Nothing in the regulations prescribed for purposes of chapter 24 (relating to income tax withholding) which provides an exclusion from ‘wages’ as used in such chapter shall be construed to require a similar exclusion from ‘wages’ in the regulations prescribed for purposes of this chapter [relating to FICA]." Thus, as a consequence of the Social Security Amendments Act of 1983, notwithstanding Rowan, the IRS and Treasury are now allowed to promulgate regulations providing different withholding exclusions for FICA and Federal income tax withholding purposes with respect to items of income. However, Anderson makes clear that these regulations cannot treat amounts that are excludable from income as subject to FICA taxes. What the regulations can do is treat items that are included in income as excludable from wages subject to Federal income tax withholding, but as not excludable from wages subject to FICA, or, conversely, as wages subject to Federal income tax withholding, but as excludable from wages subject to FICA. But, they cannot treat amounts as "‘wages’ under FICA if they are not first made ‘income.’" Anderson, 929 F.2d at 654.

Any loose language in the legislative history to the Social Security Amendments Act of 1983 suggesting that the effect of the amendment was any broader has been wisely disregarded by the Courts. There has never been any need to resort to the legislative history of the Social Security Amendments Act of 1983 because the statutory language is so clear. United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 241 (1989); American Community Builders, Inc. v. Commissioner, 301 F.2d 7, 13 (3^rd Cir. 1962); Sullivan v. United States, 46 Fed. Cl. 480, 486 (2000). Further, any general language in the legislative history to the Social Security Amendments Act of 1983 can not override Congress’ original intent in enacting the FICA tax statute or the specific intent of Congress that ESPP options and ISOs not be subjected to taxation at exercise. When Congress first enacted the social security system in 1935, it explained the newly enacted taxes as "an income tax on employees and . . . an excise tax on employers." H.R. Rep. No. 74-615 at 29 (1935); S. Rep. No. 74-628 at 21, 25 (1935). The income tax on employees was described as "a tax upon the income of every individual measured by the wages received by him with respect to employment." The tax did not apply to all wages, but only to "wages as defined in section 811 of the bill." H.R. Rep. No. 74-615 29; S. Rep. No. 74-628 at 41. The excise tax imposed on employers also was imposed on wages as defined in section 811. This legislative history strongly supports the conclusion in the Anderson line of cases that only amounts that are income can be wages. It makes clear that the employee tax is an income tax, that wages are a subset of income, and that both the employee tax and the employer tax are imposed on the same wage base, i.e., on a subset of income. Thus, it should be clear that the FICA taxes are meant to apply to a wage base, all of which is income. Nothing in the Social Security Amendments Act of 1983 changes this.

In addition, Congress explicitly made clear that there should be no taxes on exercise of statutory options. This intent was first expressed in 1950 when Congress enacted laws with respect to restricted stock options, which were the predecessors to ESPP options and ISOs. At that time, Congress explained that "Since the employee does not realize cash income at the time the option is exercised, the imposition of a tax at that time often works a real hardship." S. Rep. No. 81-2375 at 59. Congress enacted laws governing restricted stock options in order to do away with the taxation of stock options at exercise so that employees would not be forced into an "immediate sale of a portion of the stock acquired under the option . . . in order to finance the payment of the tax." In creating ESPPs and qualified stock options in 1964, and ISOs in 1981, Congress intended to extend the treatment that had been accorded restricted stock options. H. Rep. No. 88-749 at 65, 66 (1963); S. Rep. No. 88-830 at 90, 94 (1964); S. Rep. No. 97-144 at 98-99 (1981); H. Rep. No. 97-201 at 261 (1981) (The bill reinstates ‘restricted stock options,’ under which there are no tax consequences when a restricted stock option is granted or when the option is exercised, and the employee is generally taxed at capital gains rates when the stock received on exercise of the option is sold.) In light of this clearly expressed congressional intent not to impose tax at the exercise of ESPP options and ISOs, imposition of FICA taxes at exercise should not be proposed in administrative guidance. Instead, the administrative guidance should confirm that there is no income and, consequently, no wages at exercise.

As discussed above, proposed administrative guidance imposing FICA taxes on exercise of ESPP options and ISOs would be contrary to (i) the language and structure of the FICA tax statute, (ii) the case law holding that only income can be FICA wages, (iii) congressional intent regarding both the FICA tax wage base and the taxation of ESPP and ISOs, and (iv) the IRS’ own position regarding the noncompensatory nature of statutory option exercises for purposes of earnings and profits and the alternative minimum tax. In light of the above authorities, it should be clear that any administrative guidance imposing FICA taxes at exercise will be invalid. Only Congress, by amending the FICA tax statute, can make the spread on statutory options taxable at exercise, when there is no income. Congress has done just this in the case of nonqualified deferred compensation. In Code section 3121(v), Congress chose to subject nonqualified deferred compensation to FICA taxes before such compensation is income to the recipient. See Code section 3121(v)(2) in which Congress imposes FICA taxes on nonqualified deferred compensation at the later of when the services are performed or when there is no substantial risk of forfeiture of the right to the compensation. A correlative rule applies for FUTA tax purposes under Code section 3306(r)(2). Surely, the IRS would not have had the authority to impose FICA taxes on nonqualified deferred compensation before it is income by means of administrative guidance. The IRS has no more authority to impose FICA taxes at exercise of statutory stock options than it would have had to impose FICA taxes on nonqualified deferred compensation before it was income to the individual. Any attempt to issue guidance imposing FICA taxes where there is no income will be invalid. Since any such guidance would be invalid ab initio, it simply should not be issued. Instead, either the current moratorium and interim guidance should be made permanent, or guidance should be issued making clear that, because there is no income at exercise of an ESPP option or ISO, FICA taxes are not imposed on exercise of such options.

It is worth noting at this point that AeA fully supports legislative clarification to achieve the same result. The provisions of HR 2695, sponsored by Representative Amo Houghton (R-NY), were included in the Pension Security Act of 2002, HR 3762, and this package was recently approved by U.S. House of Representatives by a vote of 255-163. That Congress never intended such a tax increase is clearly indicated by this recent vote to clarify that employment taxes do not apply to transactions under statutory option plans. Sec. 301, H.R. 3762, the Pension Security Act of 2002 (Apr. 11, 2002). We respectfully submit that Treasury and the Service should obviate the need for any further Congressional action by promptly withdrawing the proposed regulations and reinstating the principles of Revenue Ruling 71-52.

1. Federal Income Tax Withholding at Disqualifying Disposition.

Again, AeA is pleased to see that a number of comments received in response to IRS Notice 2001-14 have been reflected in the proposed regulations. In particular, the IRS and Treasury should be commended for the acknowledgement in Notice 2001-72 that "An employer would have no income tax withholding obligation when an employee sells or disposes of stock acquired by the employee pursuant to the exercise of an ISO under section 422 or an option granted under an ESPP under section 423."

AeA believes this position is the correct interpretation of the law and wishes to observe that if a Federal income tax withholding obligation were to be implemented, less information regarding disposition income would be made available to employers, less disposition income would be reported as wages to employees, and less in Federal income taxes would be collected from the disposition of option stock. By contrast, the current system of employer reporting is working well now because employers have an incentive to obtain the option income information and report it to their employees, the disincentive to employees providing the employer with the information is minimal, and the employees tend to include on their individual income tax returns, and pay Federal income taxes on, the option income reported to them on Form W-2.

Therefore, AeA urges Treasury to continue to maintain, and to issue formal guidance providing, that there is no income tax withholding obligation that arises as a consequence of the sale or disposition of any stock acquired under an ESPP or through the exercise of an ISO.

1. Administrative Considerations.

The proposed regulations would increase administrative costs and therefore would discourage developing companies from offering ESPPs and ISOs to their employees. The increased compliance costs would especially burden AeA’s small member companies. Imposing FICA and FUTA withholding on the exercise of a statutory stock option would require companies that provide such options to their employees to withhold tax and report to the IRS on frequent exercises of options, in amounts dependent on valuations of the stock received pursuant to such exercises, resulting in significantly increased plan administration costs. A small company would likely be forced to hire additional administrative staff, or pay higher fees to third-party plan and payroll administrators, in order to comply with these increased obligations. The increased costs involved in complying with the proposed regulations would require such companies to divert resources from their core business operations and slow the pace of their growth. As an alternative, companies may decide not to offer statutory stock options to their employees at all, which may impair their ability to attract the best talent in a tight labor market, and place them at a competitive disadvantage compared to larger companies that may be in a better position to absorb the increased administrative costs of maintaining ISO and ESPP programs for their employees.

Requiring the withholding of FICA and FUTA taxes would pose practical problems and, in some circumstances, completely deny an employee the tax benefits intended to be available to persons exercising statutory stock options. Even if a company can afford the increased administrative costs of complying with the proposed regulations, there will be situations when a company, as a practical matter, cannot withhold FICA and FUTA from a cash payment to an employee who has exercised a statutory stock option. For example, if a former employee or their estate exercised an ISO, there would be no cash payments made by the company to such person from which to withhold FICA and FUTA. In this situation, the company likely would attempt to compel the former employee or their estate to reimburse the company for the employee's share of the FICA and FUTA tax which the company, as withholding agent, must remit to the IRS along with the company's own share. To raise the money necessary to reimburse the company, the former employee or their estate may be forced to sell the stock received upon exercise of the statutory option. A sale that so closely follows the exercise of the option would be treated as a disqualifying disposition of the stock, with the result that the former employee or their estate would lose the tax benefits otherwise afforded to persons exercising statutory stock options. In this situation, which would not be uncommon, the tax benefits intended by Congress when it enacted the ISO and ESPP provisions as a means to encourage long-term employee stock ownership would be vitiated as a result of the imposition of FICA and FUTA withholding.

We appreciate the Service's attempt to alleviate some of the administrative difficulties in withholding employment taxes in Notice 2001-73 (2001-49 I.R.B. 549). However, the Notice fails to fully address the administrative concerns, and in some ways makes administration even more burdensome.

The Notice effectively requires companies for the first time to:

• Design and implement procedures for collecting, depositing, and reporting the taxes (including a separate payroll account for tracking the "income" generated, the associated taxes, and when the taxes are considered paid);

• Modify contracts (and procedures) with third-party payroll agents and stock brokerage firms to provide for the new tasks;

• Train staff on collection procedures;

• Educate employees on tax implications; and

• Establish a process for notifying employees if the special accounting rule is used.

Although the proposed rules would provide companies with more flexibility to determine when their FICA and FUTA withholding obligations would arise during a particular year, these rules do not mitigate the cost to a company of separately tracking and accurately reporting all statutory stock option exercises, including performing an accurate valuation of the stock received upon exercise. Moreover, the proposed rules do not provide a solution to the practical problem that a company may not be able to withhold the entire amount of an employee's share of FICA and FUTA taxes attributable to exercise of a statutory stock option from future cash payments to the exercising employee.

* * * * *

As discussed above, imposition of FICA taxes on exercise of ESPP options and ISOs is inconsistent with the Code, legislative history, and case law. Imposition of Federal income tax withholding at disposition of option stock also is inconsistent with the Code and is impracticable. Consequently, the IRS and Treasury should publish administrative guidance clarifying that FICA taxes are not imposed on ESPP option or ISO exercise and that Federal income tax withholding is not required at disposition of option stock.

In the event that Treasury and the Service intend to finalize the proposed regulations, we request, at a minimum, a delayed effective date for the implementation of such regulations. The proposed regulations state that "[t]hese regulations are proposed to apply upon publication of final regulations in the Federal Register," but no earlier than January 1, 2003. We respectfully request that the effective date be delayed until the later of January 1, 2005, or 12 months after final rules are published.

The delay is essential to give companies adequate time for developing and implementing the new reporting and withholding procedures. The transition to an employment tax regime for these transactions calls for a host of information collection, system design and administrative decisions and tasks. In this regard, the rules of administrative convenience, while potentially helpful in the long run, actually complicate the transition.

AeA looks forward to presenting the above-discussed points at the hearing on May 14, 2002. In accordance, by submission of these comments, AeA requests to testify at the IRS hearing. Greg Sikon, Vice President of Tax for AeA member company, CIENA Corporation will be presenting AeA’s testimony and will be accompanied by AeA’s Tax Counsel and Director of Tax Policy, Caroline Graves Hurley. Should you need to contact AeA with regard to these comments or the hearing, please contact Caroline Graves Hurley at (202) 682-4454.

Sincerely,

William T. Archey
President & CEO

¹Although the FUTA tax statute does not reference "income" the way the FICA tax statute does, the policy reasons for not imposing taxes at exercise on an estimated amount of potential future income apply equally to FUTA taxes. These comments, nonetheless, focus on the problems with imposing FICA taxes at exercise.

²A requirement that FICA and FUTA taxes be imposed at disqualifying disposition would also be unlawful, although for completely different reasons, and, in addition, would be contrary to the IRS’ position with respect to other types of payments and would be administratively impracticable. See, e.g., Otte v. United States, 419 U.S. 43, 51 (1974); Winstead v. United States, 109 F.3d 989 (4^th Cir.1997); In re The Laub Baking Company, 642 F.2d 196 (6^th Cir. 1981); In re Armadillo Corp., 561 F.2d 1382 (10^th Cir. 1977); Consolidated Flooring Services v. United States, 42 Fed. Cl. 878 (1978) (holding that the employer for purposes of withholding the employee share of FICA taxes and paying the employer share of FICA taxes and FUTA is the person with control over the payment of the wages).

³The Claims Court opinion had not gone quite this far, but had stated that "while an exclusion from federal income tax is not determinative of whether a similar FICA tax exclusion is called for, it supports the view that a benefit or payment excluded from gross income and thus from federal income tax carries some weight in determining congressional intent relative to a FICA tax exclusion from that same benefit or payment." 16 Cl. Ct. at 540. The Claims Court concluded that Congress’ intent as reflected in the legislative history of the ODAA payments was that the ODAA payments were meant to be reimbursements for additional expenses incurred due to acceptance of an overseas assignment, and were not meant to be compensation or a salary raise in disguise. Congress’ specific intent with respect to ODAA payments was respected and the ODAA payments were held to be exempt from FICA taxes notwithstanding the broad language in the legislative history to the Social Security Amendments Act of 1983. So too, here, Congress’ intent with respect to ESPP plans and ISOs was that they should not be taxed at exercise.

⁴Revenue considerations seem to be a large part of the motivation for the proposal to impose FICA taxes on ESPP options and ISOs at exercise. The earlier Notice 2001-14 explained (at 2001-6 I.R.B. 518) that Rev. Rul. 71-52, 1971-1 C.B. 278 was published when the wage base was much lower and, consequently, "inclusion of option-related income in FICA wages would have had no effect on the FICA tax liability or Social Security benefits of most optionees (and no appreciable effect on FICA receipts)." However, nothing in Rev. Rul. 71-52 or the background file to the ruling indicates in any way that the conclusions of the ruling were based on anything but technical analysis of the application of the law that would stay the same regardless of any change in FICA tax receipts. So too, here, revenue concerns should not push the IRS and Treasury to promulgate in administrative guidance a rule that is technically unsound under the Code.

⁵The IRS has only recently acknowledged the holdings in these cases. See CCA 199933037 (June 15, 1999); CCA 199933007 (March 16, 16, 1999). In CCA 199933007, the IRS said, in discussing these cases, "Although the Service does not agree that amounts excluded from income are always excluded from wages, these cases are appellate decisions and should not be ignored in considering this issue." The holding of these cases also should not be ignored when the IRS and Treasury consider guidance on the employment taxation of ESPPs and ISO plans.