{"id":32546,"date":"2008-03-26T16:35:41","date_gmt":"2008-03-26T21:35:41","guid":{"rendered":"https:\/\/content.findlaw-admin.com\/ability-legal\/uncategorized\/irs-targets-withholding-on-employee-stock-purchase-plan.html"},"modified":"2008-03-26T16:35:41","modified_gmt":"2008-03-26T21:35:41","slug":"irs-targets-withholding-on-employee-stock-purchase-plan","status":"publish","type":"corporate","link":"https:\/\/corporate.findlaw.com\/finance\/irs-targets-withholding-on-employee-stock-purchase-plan.html","title":{"rendered":"IRS Targets Withholding on Employee Stock Purchase Plan Transactions"},"content":{"rendered":"
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After years of inconsistent action, the IRS has chosen 1998 as the year to aggressively assert that stock issued pursuant to Employee Stock Purchase Plans ("ESPPs") is subject not only to federal income tax withholding in the event of a disqualifying disposition, but also to withholding for purposes of the Federal Insurance Contributions Act ("FICA") and the Federal Unemployment Tax Act ("FUTA") upon option<\/i> exercise. 1 Worse yet, the IRS has chosen Southern California as its springboard for increased ESPP audit activities.<\/i><\/font><\/p>

In response, the Biotechnology Industry Organization and the Software Publishers Association have written to Congress requesting clarification that wage withholding is not required when stock is issued to an employee under an ESPP or when an employee makes a disqualifying disposition. In the interim, however, ESPP sponsors might benefit from reevaluating their existing withholding policies.<\/i><\/font><\/p><\/font>

Background<\/b><\/font><\/p>

More than twenty-five years ago, the IRS announced in Revenue Ruling 71-52 that income resulting from disqualifying dispositions of stock purchased through qualified stock options was not considered "wages" for FICA, FUTA or federal income tax withholding purposes. Although specifically applicable to "qualified" options (the predecessors to incentive stock options or "ISOs"), Revenue Ruling 71-52 interpreted Code provisions generally applicable to all<\/i> statutory options, thereby tacitly encouraging reliance upon Revenue Ruling 71-52 to nullify withholding obligations on disqualifying dispositions of stock purchased through ESPPs as well as ISOs. Even the IRS itself has interpreted Revenue Ruling 71-52 in this manner (see, for example, Private Letter Rulings 8225050 and 8351020).<\/font><\/p>

Sixteen years after Revenue Ruling 71-52, the IRS issued Notice 87-49 confirming that a disqualifying disposition of ISO stock is exempt from withholding. While companies and their advisors have relied upon the similarities of ISO stock and ESPP stock to validate the applicability of Revenue Ruling 71-52 to ESPP transactions, Notice 87-49 does not specifically address ESPPs. However, the IRS has yet to issue a definitive ruling requiring employers to withhold upon either ESPP option exercise or disposition of ESPP stock.<\/font><\/p>

Many companies and their advisors continue to rely upon Revenue Ruling 71-52, arguing that the IRS.s failure to provide taxpayers with FICA, FUTA, and federal income tax withholding guidelines specific to ESPPs precludes the IRS from retroactively imposing withholding obligations. The IRS, however, takes the position that FICA, FUTA, and federal income tax withholding exemptions must be explicitly mandated by Congress, and that no such exemption has ever been granted in connection with an ESPP. Despite having previously issued private letter rulings to the contrary, the IRS now insists that Revenue Ruling 71-52 was never intended to apply to ESPPs and has issued private letter rulings requiring withholding.<\/font><\/p>

The Tax Court has also touched indirectly on this issue. Most recently, in Sun Microsystems, Inc. and Consolidated Subsidiaries v. Comr., T.C. Memo 1995-69,<\/i> the Tax Court ruled that income recognized upon an ISO disqualifying disposition constitutes "wages" for purposes of the Code Section 41 research credit. Once again, however, the focus was on ISO stock rather than ESPP stock. The IRS has since acquiesced in the Sun Microsystems<\/i> decision (AOD CC-1997-010), and has recently stated internally that such acquiescence serves as notice that the IRS has changed its position with respect to withholding on ISO<\/i> transactions. In fact, we are aware of a notice of proposed adjustment that imposes income tax withholding on an ISO disqualifying disposition occurring prior to the date of the acquiescence in the Sun Microsystems<\/i> decision (November 10, 1997), where the taxpayer claimed a Section 41 research credit.<\/font><\/p>

The lack of clear authority burdens ESPP sponsors with the decision of whether or not to withhold. The June-July 1998 issue of The Advisor<\/i>, a publication of the National Association of Stock Plan Professionals, indicates that, based upon an informal survey of its members, few companies are presently withholding FICA on ESPP transactions. However, employers should be fully aware of potential penalties in the event that the IRS ultimately prevails.<\/font><\/p><\/font>

What are the Risks of Failing to Withhold?<\/b><\/font><\/p>

Social Security is financed through FICA taxes paid by employers and employees (each subject to tax at the rate of 7.65%) while unemployment benefits are financed solely from FUTA taxes imposed on employers (presently calculated at 6.2%). Although the old age, survivor and disability insurance portion of FICA (6.2%) applies only up to a maximum wage base of $68,400 in 1998, the wage base for the hospital insurance portion (1.45%) is without limit. FUTA presently has a maximum wage base of $7,000. The extent of income tax withholding depends upon the amount of wages paid to each employee.<\/font><\/p>

Employers are liable for the entire amount of FICA, FUTA and income tax required to be withheld, whether or not the tax is collected from the employee. The IRS also charges interest, at the rate of 9%, which runs from the date tax was due through the date the tax is actually received by the IRS. In addition, in the absence of "reasonable cause," Code Section 6656 imposes a penalty for failure to deposit income and employment taxes calculated as 2% of the "underpayment" if the failure continues for not more than 5 days, 5% if the failure continues for 6-15 days, 10% if the failure is for more than 15 days, and 15% if the deposit is not made by the 10th day after the IRS issues its first notice and demand for payment.<\/font><\/p><\/font>

What are the Risks of Withholding?<\/b><\/font><\/p>

It is possible that the IRS will retreat from its ESPP withholding position either because of Congressional pressure or following defeat in court. In that event, employers who adopt the present IRS position will ultimately be found to have improperly withheld and paid FICA, FUTA and income tax with respect to ESPP transactions. An employer who withholds more than the appropriate amount of employee FICA taxes or income taxes may refund such amounts to the employee, as long as the refund is made before the return for the period is filed. Alternatively, an employer may apply such erroneously collected taxes to reduce amounts which would otherwise be withheld from the employee.s future wages in the same<\/i> calendar year. If the employer neither refunds nor applies such amounts in favor of the employee, the employee may claim the excess amount as a credit against tax on his own return.<\/font><\/p>

An employer may also file a claim for refund or take a credit for the overpayment of the employer portion of social security taxes. However, to the extent that a corresponding error was made regarding the employee tax withheld, the employer cannot adjust its employer tax unless it first compensates the employee for over-collection of the employee portion.<\/font><\/p>

Footnotes<\/b><\/font><\/p>

1 A "disqualifying disposition" occurs if stock purchased under an ESPP is sold, exchanged, gifted or otherwise transferred away during a holding period which continues for two years after the grant of the option and<\/i> one year after its exercise.<\/font><\/p><\/div><\/div>","protected":false},"excerpt":{"rendered":"

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