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May 9, 2002
Mr. Guy Traynor
Acting Chief, Regulations Unit
Internal Revenue Service
CC:ITA:RU
Room 5226, IRS POB 76604
Ben Franklin Station
Washington, DC 20044

Re: REG-142686-01

Dear Mr. Traynor:

The Employment Policy Foundation (EPF) submits these comments in response to the Internal Revenue Service (IRS) notice of proposed rulemaking (Federal Register, Vol. 66, No. 220, Wednesday, November 14, 2001) regarding "Application of the Federal Insurance Contributions Act, Federal Unemployment Tax Act, and Collection of Income Tax at Source to Statutory Stock Options."

EPF is a non-partisan educational and research organization whose mission is to provide accurate and timely analysis of employment trends and policies.

Overview
The proposed rule changes the treatment of Incentive Stock Option (ISO) and Employee Stock Purchase Plans (ESPP) with respect to Federal Insurance Contribution Act (FICA) and Federal Unemployment Tax Act (FUTA) liabilities. Both types of plans enable employees to purchase company stock at a price that is below the market if company performance justifies a higher stock price in the market at the time the option is exercised by the employee. Under current law, exercise of options or stock purchase rights under statutorily qualifying ISO and ESPP arrangements does not create a compensation event for purposes of federal income tax liability of the employee or income tax withholding obligations of the employer. Income tax liability is deferred to the point at which the stock is eventually sold, and the tax liability is based on the difference (if any) between the exercise price and the sale price.

For thirty years, IRS has followed the interpretation that there is no FICA or FUTA tax liability for the employee or the employer when ISO or ESPP rights are exercised. The proposed regulation would change this long-term policy by imposing FICA and FUTA tax liabilities on employers and FICA tax liability on employees. The employer would be responsible to collect and submit the employee FICA share in addition to the employer FICA and FUTA liabilities at the time when stock options are exercised.

The proposed rule would cause employers to treat ISO and ESPP stock acquisitions differently for FICA and FUTA tax purposes than they do for federal income tax purposes. As a result, employers will have to create and maintain new, separate, distinct and duplicative information collection systems for FICA/FUTA taxes in addition to their existing systems that account for federal income taxes in relation to ISO and ESPP arrangements.

EPF finds that the proposed regulation fails to satisfy both procedural and substantive standards for acceptable public policy decisions. IRS has violated basic procedural requirements for rulemaking, and IRS is proposing a rule that will harm all Americans.

The Proposed Regulation is a Significant Regulation with Annual Cost in Excess of $100 Million

Executive Order 12866 requires agencies to conduct and report (for public comment) a full regulatory cost impact and benefits comparison analysis in the case of any regulation that may reasonably impose an annual cost in excess of $100 million on affected parties (i.e., a significant regulation). IRS asserts that the proposed regulation is not a significant regulation within the meaning of Executive Order 12866, but IRS presents in its notice to the public no information to support its finding.

EPF conducted its own independent analysis of the impact of the proposed rule. We find that the proposal will impose annual administrative cost burdens of $271.7 million to $779.5 million on affected employers in the initial year and annual costs of at least $169 million to $338 million each year thereafter. EPF's analysis shows that the proposed rule is clearly a significant regulatory action within the terms of Executive Order 12866 – its impact exceeds $100 million per year. Consequently, IRS should have conducted and published a full economic impact cost and benefits analysis of the proposed rule. Therefore, the proposed rulemaking is procedurally defective in violation of the Presidential Executive Order.

EPF's analysis identified six areas in which compliance with the proposed rule would impose administrative burdens:

• Managerial time will be required to read and understand the proposed regulation.

• Employee time (paid by the employer) will be used to inform employees of the requirements of the rule so that they can make reasonable decisions regarding participation in stock option programs.

• Managerial and administrative staff time will be needed to identify and evaluate the changes in payroll and records systems that will be needed to accommodate the new requirements of the proposed rule. The systems change requirements are significantly complicated by the awkward terms of the proposed rule that require different treatment for FICA and FUTA taxes than for Federal Income tax withholding.

• Employers will incur costs of managerial and administrative time to implement changes in systems and procedures to comply with the requirements of the proposed regulation.

• Employers will incur significant direct costs (consultant services, new software, printing, etc.) to modify software, employee manuals, and printed forms to comply with the proposed rule.

• Compliance with the proposed rule will require that employers expend additional administrative time to compute, record, collect and submit FICA and FUTA tax when stock options covered by the proposed regulation are exercised.

EPF assessed each of these cost components based on information provided by experienced payroll systems administrators and EPF findings from investigations of similar regulatory actions that affected administration and records systems. EPF estimates that between 4,000 and 8,000 employers are actively involved in ISOs or ESPPs, and that the number of employees affected is between 13 and 26 million (National Center for Employee Ownership, November 2001).

EPF analyzed two cost scenarios. Both scenarios resulted in initial year and subsequent year costs that exceed the definition of a significant regulation. Table 1, below, summarizes the parameters and results of each scenario.

Table 1 Administrative Cost Impacts of Proposed IRS Stock Options Taxation Regulation
Element	Scenario 1	Scenario 2
Affected Employers	4,000	8,000
Affected Employees	13,000,000	26,000,000
Management Familiarization Time (per employer)	4	4
Employee Information Time (per employee)	.25	0.5
Manager time to identify system modification needs	8	16
Administrative time to implement system modification	40	80
Other direct costs of system modification	$3,000	$10,000
Administrative time per option exercise	.25	0.25
Annual option exercise transactions per employee	2	2
Hourly management time cost	$43	$43
Hourly administrative time cost	$26	$26
Initial year managerial familiarization cost	$688,000	$1,376,000
Initial year employee information cost	$84,500,000	$338,000,000
Initial year systems needs assessment cost	$1,376,000	$5,504,000
Initial year systems modification internal labor cost	$4,160,000	$16,640,000
Initial year system modification other direct cost	$12,000,000	$80,000,000
Initial and recurring annual record keeping costs	$169,000,000	$338,000,000
Total initial year costs	$271,724,000	$779,520,000
Subsequent yearly costs	$169,000,000	$338,000,000

EPF's analysis of the administrative cost burdens that would be imposed by the proposed regulation is conservative. It is likely that actual impacts will be far greater than those identified by our analysis because it focused on only one narrow aspect of the regulatory impact – administrative costs to adapt record keeping and payroll systems to accommodate the proposed rules. Our analysis did not delve into the additional consequences of the actual tax liabilities that will result from imposition of the proposed regulation. Furthermore, our analysis did not address the likely impact of the proposed regulation to reduce the use of incentive stock options and employee stock purchase plans in American workplaces.

The disincentive effect of the proposed regulation – discouraging employers from offering equity ownership options to employees – would have negative economic impacts on employee wealth and on the productivity of American business in global competition that could exceed the administrative burdens by hundreds of times. This proposed regulation puts the economic welfare and jobs of millions of Americans at risk.

In sum, the proposed regulation is procedurally defective. It is a significant regulation within the terms of Executive Order 12866.

Substantive Policy Issues
The proposed regulation is presented as a "clarification" to resolve a supposed ambiguity within the tax code. In reality, the proposal is a reversal of a consistent and well-understood 30-year tax ruling. There is no record of public confusion requiring "clarification." The impetus for this regulation seems to have come from within IRS itself, not in response to any real public need.

In proposing this regulation the IRS appears to ignore a number of important public policy considerations.

• ISOs and ESPPs benefit employees at all levels in the workplace by enabling them to gain equity in the companies for which they work and to build wealth for themselves and their families. The Federal Reserve estimated in 1998 that the annual value of stock options and stock purchase rights granted to employees amounted to $1,648 per employee. Other estimates put the amount at $1,737. Based on the estimated 13 million to 26 million employees eligible to participate in ISOs and ESPPs, the annual value of these options and stock purchase rights may total $21.4 billion to $42.8 billion.

• The ISO and ESPP programs are broad-based. They benefit all levels of employees, not just highly paid executives. EPF estimates that these programs may benefit 25 percent of all private wage and salary workers today, including 9.4 million to 17.2 million hourly production workers.

• ISO and ESPP programs provide an important vehicle for supplementary retirement saving. Because income tax liability does not arise until the stock is sold, there is an incentive for employees to hold the stock acquired through these programs until retirement years when marginal tax rates may be lower. EPF estimated in March 2000 that the typical worker who received $1,700 per year in equity value would accumulate a total savings of $470,000 over a 35-year career when dividends and appreciation are included. In the face of public concerns about Social Security system insolvency and rising medical costs, such supplemental savings can provide important protections for the typical family.

• Equity participation by employees contributes to higher productivity in the American workplace. Stock ownership provides employees an added incentive to ensure that their companies are highly efficient, competitive, and profitable. A 2000 study by economists at Rutgers University showed that companies with broad-based employee stock option plans experienced 16.8 percent greater productivity growth than similar companies without such plans. The companies that offered stock options to employees experienced 2.5 percent higher annual return on assets. The result of employee equity participation is lower cost, a higher standard of living and greater job security through enhanced competitiveness. These benefits ultimately accrue to all Americans, not just the equity program participants.

The proposed IRS regulation will discourage employers from offering employees stock options and stock purchase rights and discourage employees from participating. It will discourage employers from offering stock options because it imposes new costs on employers who offer such plans. It will discourage employees from participating because the employee portion of FICA tax will be imposed on the employee at the time of option exercise.

The proposed regulation could actually lower long-term total federal tax collections. The small immediate amounts likely to be collected in FICA and FUTA payments under the proposed regulation will be off-set by reduced future income taxes that will result if the productivity, savings, and economic growth benefits of employee ownership are reduced.

Conclusion
IRS should consider the positive benefits of employee stock ownership to individual employees and to the nation before promulgating a rule that will clearly discourage employers from offering ISO and ESPP plans and discourage employees from participating. The proposed regulation is a significant regulation that should be reconsidered as procedurally and substantively flawed.

 

Respectfully submitted,

 

Edward E. Potter

President