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The Employee Ownership Update

Corey Rosen

November 15, 2001

(Corey Rosen)

IRS Proposes FICA, FUTA Withholding on ESPPs, ISOs

As expected, the IRS has proposed regulations that would require employers to withhold taxes on stock option exercises or purchases under incentive stock option (ISO) plans or employee stock purchase plans (ESPPs). The regulations were somewhat surprising, however, in that they require withholding only for FICA (social security and Medicare) and FUTA (unemployment insurance) only, not for income taxes. Companies must report the discount to the IRS and to employees on shares purchased with ISOs or under ESPPs, however, if the shares are not held long enough to qualify for capital gains treatment (one year after exercise and two years after grant).

The withholding must be done regardless of whether there is a disqualifying disposition. The IRS argued that the exercise of an ISO or the purchases of stock under an ESPP is per se income subject to FUCA and FUTA. Traditionally, this amount has not be subject to withholding by the employer for income taxes, social security, unemployment, or Medicare taxes. Social security income is currently taxable up to about $80,400; there is no cap on Medicare. Social security taxes are 6.2% of pay; Medicare is 1.45%. Both the employer and employee pay these amounts. FUTA is 6.2%, but only for the first $7,000. There are no precise numbers available on just how many people participate in ESPPs or receive ISOs. The NCEO has estimated that 15 million employees participate in an ESPP, but a minority of these are in nonqualified plans (that is, plans not qualified under Section 423 of the tax code). These plans rarely provide a discount on stock purchases and thus would not be affected by these rules. ISOs are very common in smaller companies, but affect relatively few employees in large company plans. We would estimated that not more than one to two million employees have ISOs.

Mechanics of the Proposal

The proposal allows companies to manage the withholding requirement by deeming income to be paid when it is administratively convenient to do so, within certain limits. So an employer could treat the ESPP or ISO income as occurring over a pay period, quarter, semi-annual, or other basis. An employee could also agree with the employer to pre-fund the payment of withholding. The payments-over-time method would have to be completed by December 31 of the year in which the exercise occurred. An employer could also choose to do the entire withholding at the end of the year. In an ISO, the final payment could occur at the later of termination or employment or the exercise of the option. Employers could also treat ISOs exercised in December as occurring in the next calendar year. The employee would then be required to use the same approach for personal taxes.

The proposal represents something of a compromise -- the IRS originally indicated that it would ask for withholding on disqualifying dispositions for income tax purposes as well. The proposal is subject to comments before final implementation in 2003. The tax would mean less of a gain for employees, of course, but its main impact would be that it would be an administrative nuisance, and added corporate cost, for ESPPs. Some companies have indicated the new rules will make ESPPs not worth the trouble and will terminate their plans or eliminate any discounts. For ISOs, the impact is less clear, although some experts believe it will cause a shift to nonqualified options.

There is legislation in Congress to block the IRS from imposing these rules. The House version is HR 2695 (Amo Houghton, R-NY) and in the Senate S. 1383(Hillary Rodham Clinton, D-NY). No action is scheduled yet on either bill, but now that the proposal is out, things could start moving in the next few months. It is likely that the bills would receive broad bipartisan support. The question will not so much be obtaining a majority to approve the bills as it will be getting the bills on a priority agenda given the other issues Congress is facing. Two years ago, Congress moved very quickly, and without opposition, to override a Department of Labor proposal that would have made it very difficult for companies to implement broad-based options plans. This year, however, there are many other tax bills that will compete for Congressional attention. Major employer groups are already lining up to support the new legislation.

Comments Sought

Comments on the proposal can be submitted to the IRS until February 14, 2002 by submitting them to CC:ITA:RU (Reg-142686-01), Room 5225, IRS, POB 7604, Ben Franklin Station, Washington, DC 20044. This is the general notice announcing the withholding rules. Notice 2001-72 spells out the no income tax withholding proposal; Notice 2001-73 spells out the administrative compliance procedures. Comments on these proposals should go to Associate Chief Counsel (Tax Exempt and Government Entities), CC:TEGE,ATTN: Statutory Stock Options and Income Tax Withholding (for 2001-72) or Attn: Employment Taxes, Statutory Stock Options and Proposed Rules of Administrative Convenience (for 2001-73), Room 5214, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC 20224.

One Large ESOP Closes; Another Starts

Employees have completed a $810 million transaction to purchase Appleton Papers from the French holding company Worms. The Appleton, WI company is the world's largest supplier of thermal and self-copying paper. $107 million of the transaction came from employees moving 401(k) and profit sharing plan assets into the new ESOP that was used to buy the company. Employees will own 100% of the company, which employs 2,600 people.

Another majority employee-owned company, Foster & Gallagher has closed, however. In 1998, it had over $500 million in revenue from the operation of its horticultural and gift catalogues. Over 3,000 employees worked for the company. The company had prospered by offering sweepstakes contests to induce new customers. When new rules and bad publicity caused a loss of interest in the contests, the new customers started disappearing.

IASB Begins Long Battle on Options Accounting

The International Accounting Standards Board has begun what promise to be long deliberations on developing standards for stock options accounting. At its first meetings, members of the Board seemed to concur that the measurement date for recording a compensation charge should be the date of grant. That concept has provoked the ire of numerous industry groups, some of whom have threatened to seek legislation to override any proposed standards that would require that fixed options show up as a charge to income.

Author biography and other columns in this series

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