The Employee Ownership Update
February 13, 2001
IRS Issues Significant Determinations on Options and ESOPSSeveral recent IRS announcements provide important guidance on the tax treatment of stock options and ESOPs. They are summarized below. For complete information, go to the IRS web site (www.IRS.gov) and search for the relevant material.
ESOP Distributions to Former Participants Are Not Deductible DividendsOne of the most bizarre tax court rulings of recent years was the recommendation of a magistrate for the federal district court of Idaho who recommended to the U.S. Tax Court that distributions to former ESOP participants constituted ESOP dividends deductible under Section 404(k) of the tax code. The case, Boise Cascade v. USA (11/24/98) was at odds with an August 8, 1995 IRS technical assistance memorandum (9612001) saying that distributions were not deductible dividends.
Boise Cascade maintained an ESOP. The plan allowed Boise to pay dividends from time to time to repay a loan, add to a participant's account, or be passed through directly to participants. Employees can take distributions from the plan in cash when they retire or terminate employment. The company claimed that its payment of the distributions was also a deductible dividend, notwithstanding the fact that it had already taken a deduction for contributions it had made to the plan to put stock into it. Worse still, if the distributions were treated as dividend payments, then the participants would have had to pay tax on them as passed-through dividends, would not have been able to roll them over on a pre-tax basis into an IRA, and, presumably, could have been precluded from the option of holding on to their shares to take advantage of net unrealized appreciation rules.
In Revenue Ruling 2001-6 (February 5, 2001), the IRS held that the distributions were not deductible. It argued that Section 162(k)(1) of the Internal Revenue Code ("the "Code") provides that corporate reacquisitions of stock are not tax deductible. "The application of Section 404(k) to redemption amounts not only would allow employers to claim deductions for payments that do not represent true economic costs, but also would vitiate important rights and protections for recipients of ESOP distributions, including the right to reduce taxes under Section 72, the right to make rollovers of ESOP distributions received upon separation from service, and the protection against involuntary cash-outs." Noting further that the law allows the Secretary to disallow any deductions that constitute an evasion of taxes, the IRS held that to side with the magistrate's ruling would "produce such anomalous results that Section 404(k) cannot reasonably be construed as encompassing such payments."
Corporate Deductions for Exercise of Non-Qualified Options Not Subject to AMTIn Revenue Ruling 2001-1 (2/26/01), the IRS ruled that the deductions a corporation takes on the spread of an exercise of non-qualified stock options are not disallowed as a deduction for purposes of computing the Alternative Minimum Tax.
Taxes Do Not Need to Be Withheld on Option and Stock Purchase Plan Exercises Through 2002, But IRS Seems to Be Leaning Toward Changing PolicySince 1971, companies have been relying on IRS Revenue Ruling 71-52 to avoid withholding taxes on the exercise of incentive stock options (ISOs) or stock purchased through a Section 423 employee stock purchase plan when there is a disqualifying disposition. Under either ISOs or Section 423 plans, if an employee holds on to the shares for a period of at least one year after the exercise of the right to buy shares and two years after the right was granted, the employee receives capital gains tax treatment on the spread between the grant and exercise price. If the conditions are not met, the purchase is deemed to be a "disqualifying disposition" and is subject to ordinary income tax, and the spread generates a tax deduction for the employer.
Employers have argued that they should not have to withhold taxes for these dispositions because they cannot know at the time the employee exercises the option whether they will ultimately meet the hlding requirements, nor can they easily track whether employees ultimately hold the shares for the required period. The theory was supported by a 1981 Supreme Court ruling (Rowan Companies, Inc. v. U.S. 452 U.S. 247), which held that wages and income subject to FICA (social security) and FUTA (unemployment compensation) payroll taxes were the same as wages for income tax withholding purposes. So if a company did not have to withhold the spread on a disqualifying disposition for one purpose, it did not have to withhold it for another. So if FICA and FUTA did not apply (which they rarely did, as explained below), the withholding for income taxes would not either.
In 1983, Congress reversed this ruling as part of the Social Security Amendments of 1983, stating that withholding could apply for income tax purposes even if it did not apply for FICA and FUTA. In this light, Revenue Ruling 71-52 may be outdated, the IRS argued. Moreover, in 1971, the IRS points out, the wage base for social security taxes was $4,800; today it is $80,400 (income over this amount is not subject for FICA withholding). The part attributable to health insurance included the $4,800 wage base; today, all income counts for this purpose. In 1971, options were typically granted to relatively few people and Section 423 did not exist. It would be a rare optionee indeed who did not have income over $4,800, so if withholding for FICA and health insurance was unnecessary.
In Notice 2001-14, the IRS has concluded that the "holding and principles of Rev. Ruling 71-52 do not apply to the exercise of ISOs or options granted under an ESPP." The notice states that the IRS is now reviewing the matter, and the drift of the arguments made in the proposal suggests it will rule that withholding will apply. Lacing clear guidance, however, employers may continue not to withhold for options exercised before January 1, 2003. The IRS will issue new guidance in the interim.
Comments on the reconsideration of this issue may be submitted to:
Associate Chief Counsel
Attn: Employment Taxes and Statutory Options
Internal Revenue Service
1111 Constitution Avenue NW
Washington, DC 20224
Comments must be submitted by May 7, 2001.
IRS Proposes Regulations on Notice to Interested Parties for Letters of DeterminationUnder existing law, companies seeking a letter of determination for a qualified benefit plan qualification, amendment, or termination must notify all present employees eligible to participate in the plan, all former employees still covered by the plan, and all other employees whose principal place of employment is the same that application has been made. Employees must be notified in writing, or for current employees, in a meeting, in a publication sent to employees, or by posting the notice in a place where employment-related notices are posted. The new proposed regulations allow for electronic notification of employees as well. To meet the requirements, employees either must has a computer of their own or have access to computer kiosks where employment notices are posted. Employees who do not have this access would need to be notified in other ways.
Employer Plan Compliance Resolution System Changed AgainIn recent years, the IRS has been moving to simplify its Employer Plan Compliance Resolution System (EPCRS). In Revenue Procedure 2001-17 (1/19/01), the IRS announced further organizational changes. There now will be three programs in the EPCRS. The voluntary compliance program (VCR), the Walk-In Audit Correction Program, and the tax-sheltered annuity voluntary correction program (TVC) now become a single program, the voluntary correction program (VCP). The Administrative Policy Regarding Self-Correction (APRSC) has been renamed the self-correction program (SCP). The Audit Closing Agreement Program has kept its name. The changes affect mostly the organization of existing programs, but the VCP now will allow plan sponsors to submit their request for a compliance statement anonymously. The plan only needs to be identified within three weeks after an agreement with the IRS has been reached. The proposals also clarify that self-correction of insignificant errors is allowed during a plan audit, even if the IRS discovers the erorr. On the other hand, detection of a more significant erorr by the IRS not disclosed by the plan sponsor is subject to the tougher standards of the Audit CAP program.
The detailed final regulations appear in the Code of Federal Regulations (26 CFR 601.202).