WASHINGTON, DC — May 13, 2002 — Employees who purchase company stock through their employers will be subject beginning next year to a tax increase of $23 billion over the next decade, according to government estimates, unless Congress overturns a proposed rule announced by the IRS and Treasury Department in November.

Employers are worried that the new tax will force down participation in Employee Stock Purchase Plans (ESPPs), which have for decades been a tool to enhance productivity, raise morale and give workers a stake in the success of their companies. The tax rule also will impose taxes and administrative costs on companies that offer ESPPs and incentive stock options (ISOs), which employers grant to employees. ESPPs and ISOs are both qualified stock option plans created by Congress to benefit the rank and file workforce.

The proposed rule would reverse accepted tax treatment of qualified stock options for the past 30 years. The IRS will hold a hearing May 14 (9 a.m., Auditorium, Internal Revenue Building, 1111 Constitution Avenue, N.W.) on the proposed payroll tax treatment of ESPPs and ISOs.

The House of Representatives has already approved legislation that clarifies current law affirming that the exercise of qualified stock options is excluded from payroll tax. The provision, authored by Rep. Amo Houghton (R-NY), is included in a pension reform bill (H.R. 3762). Senators Hillary Rodham Clinton (D-NY) and Pat Roberts (R-KS) have introduced an identical bill, S. 1383, and 10 members of the Senate Finance Committee wrote Treasury Secretary Paul O’Neill in April, requesting reconsideration of the proposed rule and expressing concern that it would discourage employee participation in an incentive that companies have used to spur productivity, enhance employee morale and provide savings benefits. They also noted that companies would have to incur costs to prepare to comply with the rule by summer, before Treasury has finalized the rule.

The IRS and Treasury Department announced in November [REG-142686-01] that the "spread" — the discount at which employees buy company stock under qualified plans — would become subject to payroll taxes including Social Security, Medicare, and unemployment insurance tax. The government said it would give employers until January 2003 to begin withholding the tax from employee pay.

The regulation, which has not been finalized, means that employees for the first time would be subject to tax on the difference between the market price and their purchase price of company stock made available through employers. Most employees who participate in ESPPs earn less than the FICA wage base ($84,900 in 2002) and would be subject to the 7.65 percent FICA tax. Employees over the FICA base would not be subject to the Social Security portion of FICA but would have to pay the 1.45 percent Medicare tax. Employers would be subject to the same taxes.

The effect of the IRS position would be to sharply increase the cost of the stock purchase for rank-and-file employees, making it more difficult for employees to participate. This defeats the purpose of ESPPs and ISOs, which were designed to allow employees to participate in the growth of their companies and to accumulate wealth outside of the retirement plan arena.

Federal law encourages companies to set up ESPP plans and make available stock purchases at a discount of up to 15 percent of the fair market price. Typically ESPP participants regularly set aside a portion of their "after taxes" pay to purchase stock. At the end of the contribution period, the funds may be used to buy employer stock.

Under the IRS proposal, payroll taxes must be paid on the difference between the price paid for the stock and its fair market value on the date of purchase.

Companies are unsure how to comply with the proposed rules, which essentially require them to withhold from an employee FICA tax on amounts that can only be determined when the employee purchases the stock.

In an ESPP, for example, a company may issue an option when the price of the stock is $100, allowing the employee the option to buy it at $85. If the price of the stock rises to $120 during the option period, the employee may realize a discount compared to the fair market price of $35, which would be the difference on which the payroll tax would be owed. But the discount (and the amount subject to tax) cannot be determined until the stock is actually purchased.

Employees who receive ISOs do not set up a pay withholding account but instead may exercise options by paying for them out of pocket. They and the employer are subject to the same payroll taxes as ESPP participants on the difference between the exercise price and the fair market price of the stock.

The Congressional Joint Committee on Taxation estimated that the rule would raise $23 billion in taxes over 10 years.