What is the issue? Longstanding Treasury policy held that incentive stock options (ISOs) and employee stock purchase plans (ESPPs) were not subject to employment tax withholding. The Treasury and IRS reversed this policy in 2001 by issuing proposed rules that would impose employment tax withholding on the exercise of these options beginning in 2003. Congress has a window of opportunity to return to the previous IRS policy, and legislation has been introduced to accomplish this (H.R. 2695, [Rep. Houghton, R-NY, & 32 cosponsors] and S. 1383 [Sen. Clinton, D-NY and Sen. Roberts, R-KS]). However, there may not be enough time to pass legislation before the IRS rules become effective in 2003.

What are ISOs and ESPPs? ISO plans and ESPPs provide tax-favored opportunities to obtain employer stock. There is no taxable event when an option under either program is granted to or exercised by the employee. If the employee holds the shares of stock purchased through either plan for the appropriate time periods, proceeds from the sale are taxed at capital gains rates rather than as ordinary income. ESPPs allow workers to purchase stock, usually through payroll deduction, at a discount of up to 15%, and ESPPs generally are available to all employees. ISOs are options given to workers, who typically must wait a specified period of time before they can exercise the ISOs to purchase shares. While not discussed here, ISOs and ESPPs also have their own specific limits and restrictions on the value of options or shares that may be provided to employees at any particular time.

What is the impact on companies and employees? ISOs and ESPPs are widely used by both entrepreneurial and established U.S. companies. A recent survey by the National Center for Employee Ownership (NCEO) revealed that 82% of venture-backed companies offer ISOs and 62% provide only ISOs. A separate NCEO survey indicated that 44% of all surveyed companies offered ISOs to all employees. The same survey revealed that approximately sixty-five percent of public companies offer ESPP plans, which generally cover all employees.

In 2002, workers will pay 6.2% in Social Security taxes on the first $84,900 they earn. There is no cap on Medicare, which taxes 1.45% of all wages. Companies pay an equal amount on their workers’ behalf, bringing the total up to 15.3%. In addition to the direct costs in taxes, employers will face new and heavy administrative costs in implementing the new IRS policy.

• 1971 - IRS Revenue Ruling 71-52: Social Security and federal unemployment taxes do not apply to qualified stock options.

• Mid-1990s - IRS field agents begin to assess tax deficiencies on company audits for failure to withhold employment taxes on the exercise of ISOs and ESPPs.

• April 7, 1999 - IRS formalizes change in position in notice to field agents by asserting that taxpayers should have been aware that employment taxes were payable on the exercise of ISOs and ESPPs based on a 1995 court case holding that stock options are 'wages' for the research credit under Internal Revenue Code section 41.

• January 18, 2001 - IRS issues Notice 2001-14, which provides a retroactive moratorium on the imposition of employment taxes on ISOs and ESPPs until 2003 and repeals Revenue Ruling 71-52.

• November 14, 2001 - IRS issues proposed rules in the form of Notice 2001-72 that require employment tax withholding on the exercise of ESPPs and ISOs beginning in 2003.

# # #