Background
For nearly 30 years, the Internal Revenue Service (IRS) published ruling position has been that transactions involving stock acquired by exercising ISOs and ESPPs (collectively referred to as "statutory options") do not give rise to income that is subject to payroll taxes. However, in the late 1990s, the IRS on audit and in field service advice maintained that ESPPs should be subject to payroll tax withholding.

In January 2001, the IRS announced in Notice 2001-14 that it would not impose FICA or FUTA tax on statutory stock options exercised before January 1, 2003, and would not treat the disposition of stock acquired through exercising an option as subject to income tax withholding. This represented a significant victory for AeA member companies. However, this Notice also officially changed the IRS longstanding position by suggesting it would be the intent of the IRS to require payroll tax withholding beginning in 2003.

Then, in November 2001, the IRS issued proposed regulations (Notice 2001-72 and Notice 2001-73) that provide that at the time of exercise (the purchase date for ESPPs), the individual who was granted the ISO or ESPP receives wages for FICA and FUTA purposes. The regulations require companies to withhold FICA (but not income taxes) upon exercise beginning in 2003.

For withholding purposes, the amount of wages received is the difference between the amount paid for the stock and its fair market value at the exercise of the option. As expected, the regulations provide that income tax withholding is not required at exercise or when the underlying stock is sold, although the individual may have ordinary income. If finalized as proposed the regulations would be effective only for options exercised on or after January 1, 2003.

AeA Position
AeA supports clarification either administratively or by codification that statutory stock options are not subject to payroll taxes upon grant, exercise or disposition of the stock.

Legislation preventing implementation of this proposed regulation was introduced in both the House and Senate -- HR 2695 (Rep. Amo Houghton, R-NY) and S. 1383 (Sens. Clinton, D-NY and Roberts, R-KS). These measures would clarify that the difference between the exercise price and the fair market value of stock acquired by exercising ISOs and ESPPs would be excluded from wages subject to payroll taxes. Additionally, the proposal would codify the IRS’ stated position that income tax withholding is not required on disqualifying dispositions of statutory option stock.

In April, the House of Representatives approved the Pension Security Act of 2002 (H.R. 3762) and it contains the provisions of the "Houghton bill" that would exclude ISOs and ESPPs from wages for purposes of determining payroll (FICA and FUTA) taxes. The Senate Finance Committee is expected to take up its own pension proposal later this spring. Whether or not ISO/ESPP relief is included in a Senate pension bill remains to be seen. Despite bipartisan support, the $23 billion cost of the House proposal could make it prohibitively expensive, given current budget constraints.

AeA Staff Contact
Caroline Graves Hurley, Tax Counsel, at 202-682-4454 or Caroline_Hurley@aeanet.org
May 2002