The purpose of this comment is to address certain issues arising from Field
Service Advice Memorandum 199926034 (April 7, 1999, released July 2, 1999) (the
"FSA"). The FSA addresses the application of the "FICA taxes" imposed
by §§ 3101 and 3111 of the Internal Revenue Code (the "Code") to the exercise
of options granted under an employee stock purchase plan that satisfies the requirements
of Code § 423 (an "ESPP"), and having an exercise price less than the fair
market value of the stock on the date of exercise. The FSA concludes that (i) on the
exercise date of the ESPP option, the excess of the then fair market value of ESPP stock
over the option price is FICA wages, (ii) the exercise of an ESPP option constitutes a
payment of wages, and (iii) the employer is not excused from withholding and payment of
FICA taxes for periods after the decision in Sun Microsystems, Inc. v. Commissioner,
T.C.M. 1995-69, acq. AOD CC-1997-010 (November 4, 1997). By way of background, we are
providing a summary of the pertinent guidance applicable to the issues raised by the FSA.
- NSOs
Generally, under Code § 83, the grant to an employee of an option that does not
satisfy the requirements of Code §§ 422 or 423 (a non-statutory stock option or
"NSO") will not result in the recognition of income by the employee, provided
that, at the time of grant, the option does not have a readily ascertainable fair market
value. Generally, under Code § 83 and Treas. Reg. § 1.83-7, upon exercise of the NSO for
stock that is nonforfeitable, the employee will recognize ordinary income equal to the
excess of the then fair market value of the stock over the exercise price, and the
employer will be entitled to a corresponding deduction.
- ISOs
The grant of an option that satisfies the requirements of Code § 422 (an incentive
stock option or "ISO") will not result in taxable income to the employee.
Pursuant to Code § 421(a), the exercise of an ISO will not result in taxable income to
the optionee, provided that the optionee was an employee of the employer or certain
related companies during the period beginning on the date of the grant of the option and
ending on the date three months prior to the date of exercise (subject to exceptions for
death or disability).
If the employee does not sell or otherwise dispose of the stock within two years from
the date of the grant of the ISO or within one year after the transfer of such stock,
then, upon disposition of such shares, any amount realized in excess of the exercise price
will be taxed to the employee as capital gain, and the employer will not be entitled to a
deduction for Federal income tax purposes.
Under Code § 421(b), if ISO stock is disposed of prior to satisfaction of the
foregoing holding period requirements (a "disqualifying disposition"), then, at
the time of the disposition of the shares, the employee will generally recognize ordinary
income, and a corresponding deduction will be allowed to the employer in an amount equal
to the lesser of: (i) the excess of the fair market value of the shares on the date of
exercise over the exercise price, and (ii) the excess, if any, of the amount realized upon
disposition of the shares over the exercise price. If the amount realized exceeds the fair
market value of the shares on the date of exercise, the additional amount will be capital
gain. If the amount realized is less than the exercise price, the employee will recognize
no income, and will recognize a capital loss equal to the excess of the exercise price
over the amount realized upon the disposition of the shares.
- ESPPs
The grant of an ESPP option will not result in taxable income to the employee. Pursuant
to Code § 421(a), the exercise of an ESPP option will not result in taxable income to the
optionee, provided that the optionee was an employee of the employer or certain related
companies during the period beginning on the date of the grant of the option and ending on
the date three months prior to the date of exercise (subject to exceptions for death and
disability).
If the employee does not sell or otherwise dispose of the stock within two years from
the date of the grant of the ESPP option or within one year after the transfer of such
stock, then, upon disposition of the ESPP shares (a "qualifying disposition"),
the employee will recognize ordinary income equal to the lesser of: (i) the excess of the
fair market value of the shares at the time of such disposition over the option price, or
(ii) the excess of the fair market value of the shares at the time the option was granted
over the option price. Code § 423(c). Any remaining gain is capital gain. The employer is
not entitled to any deduction upon the qualifying disposition of stock acquired pursuant
to an option granted under an ESPP.
Under Code § 421(b), if ESPP stock is disposed of prior to satisfaction of the
foregoing holding period requirements (a "disqualifying disposition"), then, at
the time of disposition of the shares, the employee will recognize ordinary income equal
to the excess of the fair market value of the stock on the date of exercise over the
option exercise price. Any remaining gain or loss shall be a capital gain or loss. The
employer will also have a deduction (which may be less than the ordinary income recognized
by the employee), provided that the disqualifying disposition is timely reported.
Although the tax treatment of ISOs and the tax treatment of ESPP options are both
governed by Code § 421, the treatment differs in one respect. Under § 423(c), if a share
of stock is purchased pursuant to an ESPP option for a price between 85% and 100% of its
fair market value as of the date the option is granted, a qualifying disposition will
result in recognition of ordinary income up to the amount of the discount from fair market
value at the time the option is granted. The exercise price of an ISO cannot be less than
100% of the fair market value of the stock at the time the option is granted, and so there
is no corresponding provision addressing such discount.