IRS Will Apply Payroll Taxes To Stock Options

by Mike Godfrey, Tax-News.com, New York

02 January 2002

Unless Congress intervenes, the IRS is about to apply payroll taxes to one of the main drivers of America's entrepreneurial boom - the widely-used incentive stock options and Section 423 employee stock purchase plans.

With ISOs, the employee may buy shares at a predetermined price that, if all goes well, is less than the market price of the stock. In the past, no taxes were due when the options are exercised and the stock purchased, and the gains would qualify for capital gains taxation if the shares were held for a year or more. Similarly, while Section 423 plans are not options, they allow employees at all levels to buy company stock at a discount of up to 15% with no immediate income tax liability.

Until this year, employers had been operating under a 1971 IRS ruling that Social Security, Medicare and other payroll taxes did not apply. Then last January, the Treasury and IRS gave notice that things would change. Beginning in January 2003, they said, income from the exercise of ISOs or from Section 423 plans would be subject to payroll taxes. The taxes would apply to the "spread," or difference, between the fair market value of the stock when purchased and the price actually paid by the employee or option holder.

"Treasury and the IRS did not go out of their way to find that Social Security tax applies to options, but there was no authority to refrain from enforcing a statute that contained no applicable exception," said Mark Iwry, a senior Treasury official.

The Arlington-based National Venture Capital Association, whose members finance many small, young companies that use options to retain top talent, terms the new policy a "key issue" on its legislative agenda, and bills have been introduced in both houses of Congress to fix the problem.

However, Iwry said what the Treasury and IRS have done "is faithful to the statute, flexible and fair." He said that beginning with the notice last January, the agencies have given employers two years to comply and Congress the same interval "to consider whether a change in the law is appropriate."

"It's for the legislative process to weigh the policy issues, including the uses and value of ISOs and stock purchase plans, their appropriate Social Security tax treatment, and the impact an exemption might have on employees' Social Security benefits or on the solvency of the Social Security trust funds," Iwry said.

Employers and employees are both responsible for paying payroll taxes, but employers are on the hook for making sure that employees pay, and that can be a real problem when options are exercised by ex-employees.

Recommended