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April 23, 2002 CC:ITA:RU (REG-142686-01) Re: IRS Notices 2001-72 and 2001-73 and Notice of Proposed Rulemaking regarding FICA and FUTA Tax Withholding on Stock Options Dear Sir or Madam: I am writing on behalf of the American Benefits Council (the Council) to provide the Council's comments on proposed guidance regarding the employment tax withholding treatment of Internal Revenue Code (Code) § 423 employee stock purchase plans (ESPPs) and Code § 422 incentive stock option (ISO) plans. These types of stock plans are collectively referred to in this letter as 'statutory stock options.' The Council is a public policy organization representing principally Fortune 500 companies and other organizations that assist companies of all sizes in providing benefits to employees. Collectively, the Council's members either sponsor directly or provide services to stock, retirement and health plans that cover more than 100 million Americans. First, the Council supports and appreciates the decision of the Internal Revenue Service (IRS) and the Department of the Treasury to exempt statutory stock options from income tax withholding upon exercise or upon a disqualifying disposition. Second, we disagree with the position of the Treasury and IRS with regard to the application of Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) to statutory stock options. For the public policy, legal and administrative reasons discussed below, the Council recommends that prospective administrative guidance permanently exempt such stock option transactions from employment tax withholding. Public Policy Reasons Council member companies and service providers are increasingly extending the benefits of stock ownership to their employees through stock ownership programs, including statutory stock option plans. This trend in our membership is reflective of the growth of stock ownership programs generally. According to the National Center for Employee Ownership, approximately 10 million employees, many of whom are rank-and-file workers, possess stock options. There are important public policy reasons for encouraging the growth of stock ownership programs. Broad-based stock ownership programs prove valuable to both employees and employers as well as to the overall economy.
Burdensome tax withholding rules would be detrimental to the use of broad-based stock plans, resulting in decreased employee participation in existing statutory stock option plans, termination of existing plans and less willingness on the part of businesses to provide them in the future. Specifically, imposing employment taxes on ESPPs and ISOs would subject a large number of de minimis amounts to withholding and reporting, placing an undue burden on plan administration. As is discussed below, compliance with employment tax withholding will be extremely difficult -- especially as it would apply to former employees -- because upon grant, exercise, or disposition, there is no employer distribution of cash from which to withhold. In fact, this treatment is grossly inconsistent with Treasury decisions on the withholding requirements relating to other employee benefits. For example, in the qualified plan area, the IRS has recognized this difficulty and has not required withholding when only employer stock is distributed. Temp. Treas. Reg. § 35.3405-1T, Q&A A-29. Similarly, for retiree group term life insurance, the employer is not required to withhold the employee's share of FICA. Code § 3102(d). Accordingly, if employment taxes are imposed upon exercise, it would force current employees into an immediate disqualifying disposition of stock to cover the withholding for the employee's share of the FICA and FUTA burden. Forcing an immediate sale upon exercise would frustrate Congress' clear intent in enacting these programs of encouraging long-term holding of equity by employees, many of whom would be lower-income, rank-and-file workers. Legal Reasons In addition to public policy reasons, the Council believes that the law exempts statutory stock option transactions from the reach of employment and income tax withholding. In order to lay the foundation for our arguments, this letter first provides the framework for the tax treatment of statutory stock options. A. Employment Tax Obligation Section 3101 of the Code imposes a tax on the income of an individual received with respect to employment for Old-Age, Survivors, and Disability Insurance and for Hospital Insurance (together referred to as the "FICA" tax). Under Code § 3102, an employer is required to withhold FICA taxes on "wages" (as defined in Code § 3121) paid to an employee and, under Code § 3111, the employer is required to pay a corresponding additional FICA tax. Under Code § 3301, which reflects the FUTA tax, an employer is required to pay FUTA taxes on "wages" (as defined in Code § 3306) paid to an employee. B. Employment Tax Withholding of Statutory Stock Option Transactions FICA and FUTA taxes cannot be imposed upon the grant or exercise of statutory stock options because there is no income, and thus no wages, as a result of the exercise of the option. Wages are a subset of "income;" without income there cannot be wages for employment tax purposes. As noted above, income results neither from the grant or exercise of statutory stock options nor upon certain dispositions of such option stock. Specifically, Code section 421(a)(1) states that, "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;" (emphasis added). The IRS has recognized the validity of this "no income, and therefore, no wages" analysis in recent chief counsel advice ("CCA") memoranda 199933007 and 199933037. Specifically, in CCA 199933007, the IRS stated that:
The Rowan decision held that the definition of "wages" for Social Security tax purposes and the definition of "wages" for income tax purposes must be interpreted in regulations in the same manner in the absence of statutory provisions to the contrary. Rowan Companies, Inc. v. United States, 452 U.S. 247 (1981). In response, Congress amended §§ 3121(a) (definition of "wages" for FICA purposes) and 3306(b) (definition of "wages" for FUTA purposes) of the Code by adding the following flush language, effective for all remuneration paid after 1983:
This language is not applicable to the grant or exercise of statutory stock options because the exclusion from wages is set forth in the statute itself, and not in income tax regulations. For example, Code § 3101 states that FICA is imposed on the "income" of every individual equal to a percentage of "wages." Code §§ 3101(a), (b). As the court held in Anderson, Congress has already provided an exemption from FICA for statutory stock option transactions by the language and structure of the FICA tax statute, which conditions imposition of FICA taxes on income. Moreover, the nature of any gain from exercise and disposition of statutory option stock is quite distinct from employment wages. Any gain recognized on a disposition is generated by an employee's decision, unrelated to employment, to dispose of the stock. The extent to which any income will be recognized is undeterminable at the time of grant or exercise. For example, if the stock is sold in a qualifying disposition at a loss, no income is recognized. Therefore, imposing FICA and FUTA taxes on grant or exercise would result in taxation of amounts that may never be recognized. As a result, the imposition of FICA and FUTA taxes on statutory stock option transactions would be inappropriate. Administrative Reasons Notice 2001-73 provides proposed rules of administrative convenience relating to application of FICA and FUTA tax withholding on exercise of statutory stock options. We are pleased that, in issuing Notice 2001-73, the Treasury and IRS recognized the administrative burdens that would result from the application of employment tax withholding on statutory stock options. However, the Council does not believe that the proposals contained in Notice 2001-73 adequately address the significant administrative problems of collecting employment taxes upon exercise of statutory stock options. If withholding were required, compliance would be particularly difficult because the employer does not pay any amounts to the employee (particularly a former employee) in a stock disposition from which the employer can withhold taxes. While Notice 2001-73 provides more flexibility for the collection of FICA and FUTA taxes in this situation, it does not provide clear and complete answers to the variety of issues that may arise. For example, there will be situations when withholding cannot be done, such as when an employee terminates employment or is on unpaid leave, and the notice does not give complete guidance on this problem. Statutory stock option programs are typically administered by third parties who have no ability to withhold taxes from wages or other payments. In addition, the proposed rules of administrative convenience do not clarify whether the employee and employer are still responsible for payment of FICA and FUTA taxes if the sales price of the stock is less than the exercise price. It is also unclear whether and how an employer may advance the amount of withholding to an employee as well as what the tax implications of such an advance would be. There may also be unintended negative consequences from the proposed rules. If a company withholds an additional amount from other wages for purposes of pre-funding the employment tax withholding on statutory stock options, state wage withholding laws may be implicated. The proposed rules of administrative convenience do not provide any significant relief from the costs and burdens of this new employment tax liability. The Council strongly believes that employers, employees and the government will bear a significant burden of compliance. Given that this tax obligation was not imposed in prior decades, we do not understand the need to impose enforcement of employment tax withholding that is impractical and costly. We note that the IRS recently took a position of non-enforcement on the issue of frequent flyer awards, in part due to "numerous technical and administrative issues related to these benefits." We recommend that the Treasury and IRS consider similar concerns with respect to statutory stock options. At the very least, the Treasury and IRS should explore the various issues of practicality more thoroughly and with more input from industry than they have to date. * * * The Council respectfully requests that the IRS issue guidance that exempts statutory stock options from employment tax withholding for the reasons discussed above. We would be pleased to provide any assistance in such a review. Please do not hesitate to contact me or John Scott, Director, Retirement Policy, if you or your staff needs any further information or assistance in this matter. Sincerely, James M. Delaplane, Jr. cc: Mark A. Weinberger |
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This page was last updated on 05/09/02. 