Selected Issues in Equity Compensation

From Chapter 1, "Administering an Employee Stock Option Plan"

Where the optionee is an employee of the company, arrangements must be made to satisfy any withholding tax obligations that arise in connection with the exercise of an NSO. If the optionee is a local employee, generally any withholding tax payment due should accompany delivery of the stock option exercise notice. If the optionee is not a local employee, generally the date of exercise will be considered to be the date on which an executed stock option exercise notice is received by the company via facsimile or electronic transmission and/or funds representing the total required option exercise price for the number of option shares being purchased are wired to the company. The original exercise notice is then mailed to the company along with the necessary withholding tax payment, if applicable. Relevant withholding taxes may include:

• Federal income
• Social Security insurance portion of the Federal Insurance Contributions Act (FICA)
• Medicare insurance portion of FICA
• State income (if applicable)
• State disability or unemployment (if applicable)

Where not addressed in the employee stock option plan or the grant agreement, the company may adopt a formal policy establishing the date on and price at which any applicable income and withholding taxes will be calculated. In accordance with Section 83 of the Code, the applicable taxes will be calculated based on the fair market value of the company's stock on the exercise date. If the amount of withholding taxes due cannot be calculated in advance, the policy usually states the time period within which the withholding tax payment must be received by the company. Frequently, a company will hold the certificate for the option shares purchased until full payment of all amounts due is received.

Typically, a company can withhold these taxes one of two ways. First, the compensation income resulting from the option exercise may be aggregated with an employee's regular salary payment for the period, with withholding computed on the total amount. Depending upon the vesting arrangements for the option, this compensation income may be determined at the time of exercise or, if exercised prior to vesting, at the time of vesting. Alternatively, the compensation income is eligible for withholding at the flat rate for supplemental wage payments.

In addition, employment taxes under FICA and the Federal Unemployment Tax Act (FUTA) may be due. FICA is made up of two separate taxes: (1) old age, survivor, and disability insurance (Social Security); and (2) hospital insurance (Medicare). The Social Security component of FICA is collected up to an annual maximum, which changes annually. The Medicare component is collected against the employee's total income. A company's payroll department should notify its stock plan professionals when any rate changes occur. FICA taxes are imposed on both the employee and the company, while FUTA taxes are levied against the company alone.