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On Nov. 13, the Internal Revenue Service proposed regulations (REG-142686-01) that would impose Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) employment taxes on the exercise of incentive stock options issued under Internal Revenue Code Section 422 (ISOs), and options granted pursuant to employee stock purchase plans governed by Code Section 423 (ESPPs). At the same time, the IRS issued two related notices. Notice 2001-73 provides proposed “rules of administrative convenience” designed to help employers comply with the administrative burdens of the new regulations. Notice 2001-72 proposes a specific exemption from income tax withholding for disqualifying dispositions of stock acquired upon exercise of ISOs and ESPP options. Although the proposed regulations are not set to take effect until Jan. 1, 2003, they will likely be the subject of intense debate in the coming months among practitioners, lawmakers and the IRS. The Notices will not be effective until issued with final rules, which the IRS says it expects to issue in conjunction with the finalization of the proposed regulations. BACKGROUND It is well established that employment tax and income tax withholding obligations arise on an employee’s exercise of non-qualified stock options. The rules relating to the exercise of an ISO or an ESPP option have been less certain. What is clear is that an employee does not recognize income when an ISO or an ESPP option is granted or when the employee exercises such option, and that when ISO stock is sold after the required holding period (i.e., after the stock has been held for two years after the grant of the option and one year after the stock is transferred to the employee upon exercise), any appreciation on the stock is taxed at capital gains, not ordinary income, rates. A similar rule applies to ESPP option stock sold after the required holding period, although a portion of the appreciation may be taxed as ordinary income. Therefore, no income tax withholding is required at any point in the transaction. However, an employer’s income tax withholding obligation in the event of a disqualifying disposition (i.e., one before the end of the required holding period), is less certain. Further, the imposition of employment taxes on the exercise of ISOs and ESPP options has been the subject of various IRS interpretations in the past. Earlier this year, in Notice 2001-14, the IRS stated that it planned to issue definitive guidance on these issues but that, in the meantime, it would not impose FICA or FUTA taxes on the exercise of ISOs or ESPP options until 2003, at the earliest. Further, with respect to all dispositions of stock acquired pursuant to the exercise of ISOs or ESPP options, the IRS stated that it would not require income tax withholding. Notice 2001-14 applies to exercises and dispositions after publication of the Notice and before Jan. 1, 2003. While Notice 2001-14 provided interim relief, it indicated that the IRS believed there was a lack of statutory authority to continue to exempt exercises of ISOs and ESPP options from the imposition of FICA and FUTA taxes. Due to the potential time and costs that would be involved in administering the collection by employers of FICA and FUTA taxes in these transactions, practitioners and employers continued to hope that the IRS’s position outlined in Notice 2001-14 would become permanent. EMPLOYMENT TAX OBLIGATIONS ON EXERCISE OF ISOS AND ESPP OPTIONS The proposed regulations provide that the amount by which the fair market value of stock acquired upon exercise of an ISO or an ESPP option exceeds the option exercise price will be subject to FICA and FUTA taxes. The proposed regulations, however, confirm that no federal income tax withholding will be required upon exercise of an ISO or ESPP option. The proposed regulations issued by the IRS reflects its view that the Code defines “wages” for FICA and FUTA tax purposes broadly, and that there are no statutory exclusions for exercises of ISOs and ESPP options. The IRS also stated it finds no reason to distinguish ISOs and ESPP options from non-qualified stock options for purposes of imposing FICA and FUTA taxes on the exercise of such options. The proposed regulations would apply to the exercise of ISOs and ESPP options on or after Jan. 1, 2003 but will not become effective until published as final regulations in the Federal Register. RULES OF ADMINISTRATIVE CONVENIENCE In Notice 2001-73, issued in conjunction with the proposed regulations, the IRS proposed several alternatives to assist employers and employees in meeting the employment tax obligations outlined in the proposed regulations: Payment Periods: An employer may treat the wages arising upon exercise of an ISO or ESPP option as paid over one or more periods based on a pay period, quarter, half year, year or other basis. All taxes must, however, be paid by December 31 of the year of exercise. The employer would be permitted to change the method used at any time, but must apply this rule consistently to all employees participating in its stock option plans. Special Accounting Rule: The employer may treat wages resulting from exercise of an ISO or ESPP option in December as paid in the first quarter of the next calendar year. If this accounting rule is used, it must apply for both the employer and the employee. The employer must notify employees if this rule is used. The employer will be required to apply this rule consistently to all employees participating in its stock option plans. Employee Prefunding of FICA Tax: An employer and employee may contractually arrange for the employee to prefund the employee’s portion of the FICA tax. Employer Advance of FICA Taxes: An employer is allowed to advance the employee’s portion of the FICA tax and receive reimbursement from the employee’s future wages. INCOME TAX WITHHOLDING OBLIGATIONS ON DISPOSITION OF ISO AND ESPP OPTION STOCK Notice 2001-72, also issued in conjunction with the proposed regulations, would officially relieve employers from income tax withholding obligations on an employee’s sale or disposition of stock acquired upon exercise of an ISO or an ESPP option and in the case of a disqualifying disposition of the stock (one that occurs during the required holding period, described above). Notice 2001-72, while relieving employers of their income tax withholding obligations in these circumstances, will require an employer to make reasonable efforts to ascertain whether it must report any amounts realized upon disqualifying dispositions on Form W-2. Under the Notice, an employer will not be treated as making a reasonable effort if it claims a deduction under Section 83 for the amount of the compensation, but fails to report the compensation on Form W-2. Note that any appreciation in the stock that is taxed as capital gain on the disposition of ISO or ESPP option stock (even if a disqualifying disposition) is not considered wages subject to reporting. The Notice fails to describe what will constitute “reasonable efforts” to determine whether any amounts realized upon a disposition of ISO or ESPP option stock must be reported. Employers already have a tax incentive for tracking disqualifying dispositions of ISO and ESPP option stock because they are able to deduct the amount of compensation income recognized by employees. Accordingly, many option plans already require employees to report the disposition of option stock. Hopefully this would be considered “reasonable efforts” by the employer even if the employee failed to comply. CURRENT FICA AND FUTA TAX RATES FICA tax is comprised of a tax for Old-Age, Survivors and Disability Insurance, or OASDI, and a tax for Hospital Insurance, or HI. The OASDI portion of FICA tax, also known as Social Security tax, is imposed separately on each of the employer and the employee in an amount equal to 6.2 percent of wages. The maximum amount of wages subject to OASDI tax for 2002 will be $84,900. The HI portion of FICA tax, also known as Medicare tax, is also imposed separately on each of the employer and the employee in an amount equal to 1.45 percent of wages, without any limit. FUTA tax is imposed on the employer in an amount equal to 6.2 percent of wages. The maximum amount of wages subject to FUTA tax in 2002 will be $7,000. EXPECTATIONS FOR THE FUTURE Many practitioners are hopeful that the publicity surrounding the issuance of the proposed regulations and the negative reaction to the regulations from practitioners, commentators and some members of Congress will lead to Congressional action on this issue. In the meantime, the IRS has requested that comments on the proposed regulations be submitted by Feb. 14, 2002. A hearing on the proposed regulations and the Notices will be held on March 7, 2002. Joseph Yaffe is an associate in the Tax Department of Latham & Watkins’ Silicon Valley office. He may be reached at (650) 328-4600.

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